 Olk |
Woodsam |
Tufts |
Midland |
| Inaja |
Cottage |
Threlkeld |
Mt.
Morris |
| Olk |
Woodsam |
Tufts |
Midland |
| Inaja |
Cottage |
Threlkeld |
Mt.
Morris |
WENDELL OLK, Plaintiff-Appellee, v. UNITED STATES OF
AMERICA, Defendant-Appellant
No. 75-2181
UNITED STATES COURT OF APPEALS FOR THE NINTH CIRCUIT
536 F.2d 876; 1976 U.S. App. LEXIS 8795; 76-2 U.S. Tax Cas.
(CCH) P9484; 38 A.F.T.R.2d (RIA) 5219
OPINION: [*876] SNEED, Circuit Judge:
This is a suit to obtain a refund of federal income taxes. The issue is
whether monies, called "tokes" in the relevant trade, received by the taxpayer,
a craps dealer employed by Las Vegas casinos, constitute taxable income or gifts
within the meaning of section 102(a), INT. REV. CODE of 1954. The taxpayer
insists "tokes" are non-taxable gifts. If he is right, he is entitled to the
refund for which this suit was brought. The trial court in a trial without a
jury held that "tokes" were gifts. The Government appealed and we reverse and
hold that "tokes" are taxable income.
[*877] I. The Facts.
There [**2] is no dispute about the basic facts which explain the setting
in which "tokes" are paid and received. The district court's finding with
respect to such facts which we accept are, in part, as follows:
In 1971 plaintiff was employed as a craps dealer in two Las Vegas gambling
casinos, the Horseshoe Club and the Sahara Hotel. The basic services performed
by plaintiff and other dealers were described at trial. There are four persons
involved in the operation of the game, a boxman and three dealers. One of the three dealers, the stickman, calls the roll of the dice and then collects them
for the next shooter. The other two dealers collect losing bets and pay off
winning bets under the supervision of the boxman. The boxman is the casino
employee charged with direct supervision of the dealers and the play at one
particular table. He in turn is supervised by the pit boss who is responsible
for several tables. The dealers also make change, advise the boxman when a
player would like a drink and answer basic questions about the game for the
players.
Dealers are forbidden to fraternize or engage in unnecessary conversation
with the casino patrons, and must remain in separate areas [**3] while on
their breaks. Dealers must treat all patrons equally, and any attempt to
provide special service to a patron is grounds for termination.
At times, players will give money to the dealers or place bets for them. The
witnesses testified that most casinos do not allow boxmen to receive money from
patrons because of their supervisory positions, although some do permit this.
The pit bosses are not permitted to receive anything from patrons because they
are in a position in which they can insure that a patron receives some special
service or treatment.
The money or tokes are combined by the four dealers and split equally at the
end of each shift so that a dealer will get his share of the tokes received even
while he is taking his break. Uncontradicted testimony indicated that a dealer
would be terminated if he kept a toke rather than placed it in the common fund.
Casino management either required the dealers to pool and divide tokes or
encouraged them to do so. Although the practice is tolerated by management, it
is not encouraged since tokes represent money that players are not wagering and
thus cannot be won by the casino. Plaintiff received about $10 per day as his
[**4] share of tokes at the Horseshoe Club and an average of $20 per day in
tokes at the Sahara. (footnotes omitted).
Additional findings of fact by the district court are that the taxpayer
worked as a stickman and dealer and at all times was under the supervision of
the boxman who in turn was supervised by the pit boss. Also the district court
found that patrons sometimes give money to dealers, other players or mere
spectators at the game, but that between 90-95% of the patrons give nothing to a
dealer. No obligation on the part of the patron exists to give to a dealer and
"dealers perform no service for patrons which a patron would normally find
compensable." Another finding is that there exists "no direct relation between
services performed for management by a dealer and benefit or detriment to the
patron."
There then follows two final "findings of fact" which taken together
constitute the heart of the controversy before us. These are as follows:
17. The tokes are given to dealers as a result of impulsive generosity or
superstition on the part of players, and not as a form of compensation for
services.
18. Tokes are the result of detached and disinterested [**5] generosity on
the part of a small number of patrons.
These two findings, together with the others set out above, bear the
unmistakable imprint of Commissioner v. Duberstein, 363 U.S. 278, 4 L. Ed. 2d
1218, 80 S. Ct. 1190 (1959), particularly that portion of the opinion which
reads as follows:
The course of decision here makes it plain that the statute does not use the
term "gift" in the common-law sense, but [*878] in a more colloquial sense.
This Court has indicated that a voluntary executed transfer of his property by
one to another, without any consideration or compensation therefor, though a
common-law gift, is not necessarily a "gift" within the meaning of the statute.
For the Court has shown that the mere absence of a legal or moral obligation to
make such a payment does not establish that it is a gift. Old Colony Trust Co.
v. Commissioner, 279 U.S. 716, 730, 73 L. Ed. 918, 49 S. Ct. 499. And,
importantly, if the payment proceeds primarily from "the constraining force of
any moral or legal duty," or from "the incentive of anticipated benefit" of an
economic nature, Bogardus v. Commissioner, 302 U.S. 34, 41, 82 L. Ed. 32, 58 S.
Ct. 61, it is [**6] not a gift. And, conversely, "where the payment is in
return for services rendered, it is irrelevant that the donor derives no
economic benefit from it." Robertson v. United States, 343 U.S. 711, 714, 96 L.
Ed. 1237, 72 S. Ct. 994. A gift in the statutory sense, on the other hand,
proceeds from a "detached and disinterested generosity," Commissioner Of
Internal Revenue v. LoBue, 351 U.S. 243, 246, 100 L. Ed. 1142, 76 S. Ct. 800;
"out of affection, respect, admiration, charity or like impulses." Robertson v.
United States, supra, at 714. And in this regard, the most critical
consideration, as the Court was agreed in the leading case here, is the
transferor's "intention." Bogardus v. Commissioner, 302 U.S. 34, 43, 82 L. Ed.
32, 58 S. Ct. 61. "What controls is the intention with which payment, however
voluntary, has been made." Id., 302 U.S. at 45 (dissenting opinion).
Id. 363 U.S. at 285-86 (footnotes omitted).
II. Finding Number 18 Is A Conclusion of Law.
The position of the taxpayer is simple. The above findings conform to the
meaning of gifts as used in section 102 of the Code. Duberstein further
teaches, the taxpayer asserts, [**7] that whether a receipt qualified as a
non-taxable gift is "basically one of fact," id. 363 U.S. at 290, and appellate
review of such findings is restricted to determining whether they are clearly
erroneous. Because none of the recited findings are clearly erroneous,
concludes the taxpayer, the judgment of the trial court must be affirmed.
We could not escape this logic were we prepared to accept as a "finding of
fact" the trial court's finding number 18. We reject the trial court's
characterization. The conclusion that tokes "are the result of detached and
disinterested generosity" on the part of those patrons who engage in the
practice of toking is a conclusion of law, not a finding of fact. Finding
number 17, on the other hand, which establishes that tokes are given as the
result of impulsive generosity or superstition on the part of the players is a
finding of fact to which we are bound unless it is "clearly erroneous" which it
is not.
The distinction is between a finding of the dominant reason that explains the
player's action in making the transfer and the determination that such
dominant reason requires treatment of the receipt as a gift. Finding number 17
is addressed [**8] to the former while number 18 the latter. A finding
regarding the basic facts, i.e., the circumstances and setting within which
tokes are paid, and the dominant reason for such payments are findings of fact,
our review of which is restricted by the clearly erroneous standard. Whether
the dominant reason justifies exclusion from gross income under section 102 as
interpreted by Duberstein is a matter of law. Finding number 18 is a
determination that the dominant reason for the player's action, as found in
number 17, justifies exclusion. This constitutes an application of the statute
to the facts. Whether the application is proper is, of course, a question of
law.
Our view is supported by Judge Sobeloff's opinion in Poyner v. Commissioner,
[*879] 301 F.2d 287 (4th Cir. 1962). He drew a line between the basic facts,
the actual happenings, and a finding of the "dominant reason" for the payments
on the one hand and the determination whether the "dominant reason" justified
exclusion from gross income on the other. The latter requires an application of
the law to the facts and with respect to it the appellate court may make an
independent judgment. Id. at 290. [**9]
This is a sensible approach. Otherwise an appellate court's inescapable duty
of appellate review in this type of case would be all but foreclosed by a
finding, such as in number 18, in which the resolution of the ultimate legal
issue was disguised as a finding of fact. The error in insisting that findings
numbers 17 and 18 are both findings of fact with respect to the "dominant
reason" is revealed when the language of finding number 18 is compared with
Duberstein's statement, "A gift in the statutory sense, on the other hand,
proceeds from a 'detached and disinterested generosity,' Commissioner Of
Internal Revenue v. LoBue, 351 U.S. 243, 246, 100 L. Ed. 1142, 76 S. Ct. 800;
'out of affection, respect, admiration, charity or like impulses.'" 363 U.S. at
285. Their similarity is not coincidental and demonstrates that finding number
18 is but an application of the statutory definition of a gift to all previous
findings of fact including finding number 17. Number 18 merely characterizes
all previous findings in a manner that makes classification of the receipt as a
gift inevitable. "Detached and disinterested generosity" are, by reason of
Duberstein, the operative words [**10] of the statutory definition of a gift.
To apply them to facts, including a finding with respect to "dominant motive" is
to apply the statute to such facts. It is a conclusion of law.
III. Finding Number 18 and Other Conclusions of Law Based Thereon Are
Erroneous.
Freed of the restraint of the "clearly erroneous" standard, we are convinced
that finding number 18 and all derivative conclusions of law are wrong.
"Impulsive generosity or superstition on the part of the players" we accept as
the dominant motive. In the context of gambling in casinos open to the public
such a motive is quite understandable. However, our understanding also requires
us to acknowledge that payments so motivated are not acts of "detached or
disinterested generosity." Quite the opposite is true. Tribute to the gods of
fortune which it is hoped will be returned bounteously soon can only be
described as an "involved and intensely interested" act.
Moreover, in applying the statute to the findings of fact, we are not
permitted to ignore those findings which strongly suggest that tokes in the
hands of the ultimate recipients are viewed as a receipt indistinguishable,
except for erroneously anticipated [**11] tax differences, from wages. The
regularity of the flow, the equal division of the receipts, and the daily amount
received indicate that a dealer acting reasonably would come to regard such
receipts as a form of compensation for his services. The manner in which a
dealer may regard tokes is, of course, not the touchstone for determining
whether the receipt is excludable from gross income. It is, however, a
reasonable and relevant inference well-grounded in the findings of fact.
Our view of the law is consistent with the trend of authorities in the area
of commercial gratuities as well as with the only decision squarely in point,
Lawrence E. Bevers, 26 T.C. 1218 (1956), and this Circuit's view of tips as
revealed in Roberts v. Commissioner, 176 F.2d 221 (9th Cir. 1949).
Generalizations are treacherous but not without utility. One such is that
receipts by taxpayers engaged in rendering services contributed by those with
whom the taxpayers have some personal or functional contact in the course of the
performance of the services are taxable income when in conformity with the
practices of the area and easily valued. Tokes, like tips, meet these
conditions. That is enough. [**12]
The taxpayer is not entitled to the refund he seeks.
REVERSED.
Inaja Land Company, Ltd., a Corporation, Petitioner, v.
Commissioner of Internal Revenue, Respondent
UNITED STATES TAX COURT
9 T.C. 727
October 21, 1947, Promulgated
DISPOSITION: Decision will be entered for the petitioner.
SYLLABUS: 1. The payment of the sum of $ 50,000 to petitioner in 1939 by the
city of Los Angeles in consideration of the conveyance by it to the city of a
right of way and certain easements to divert foreign waters into the Owens River
as it flowed through petitioner's land, and releasing the city from all claims
and demands, etc., did not constitute taxable income to petitioner under section
22 (a), I. R. C.
2. Since, under the circumstances, it was practically impossible to allocate
a basis to the easements granted, the net amount received, being less than the
petitioner's basis for the entire property, will merely reduce that basis.
Burnet v. Logan, 283 U.S. 404.
OPINION: [*727] This proceeding involves deficiencies in Federal income and
declared value excess profits taxes for the taxable year 1939 in the amounts of
$ 8,777.22 and $ 5,393.51, respectively.
The issue is whether petitioner received taxable income of $ 48,945 under a
certain indenture of August 11, 1939, whereby it granted the city of Los
Angeles, California, certain easements over its land and settling all claims
arising out of the release of foreign waters from the city's Mono Craters Tunnel
project. Certain facts have been stipulated and are so found. Facts found
other than those stipulated are found from the evidence.
FINDINGS OF FACT.
Petitioner is a stock corporation, organized under the laws of California,
with its principal office at 816 South Figueroa Street, Los Angeles, California.
Petitioner's income and declared value excess profits tax return for the
calendar year 1939 and its capital stock tax return for the fiscal year ended
June 30, 1939, were filed with the collector of internal revenue for the sixth
district of California.
On or about January 26, 1928, petitioner acquired approximately 1,236 acres
of land in Mono County, California, together with all water and water rights
appurtenant or belonging thereto, at a cost of approximately $ 61,000. This
property was located along the banks of the Owens River, which flows through and
over petitioner's land, [*728] involved in this controversy. The land was 2
1/2 miles long and 1 1/2 miles wide at its farthest extremities and included the
following classifications:
Acres
Rocky hill lands 419
Irrigated rocky pasture 195
Dry rocky pasture 104
Irrigated meadows 358
Dry tillable brush 160
Total 1,236
When the property was acquired in 1928 there were two small cabins or shacks
located thereon. In 1940 petitioner purchased and moved onto the property two
cabins, one to replace the southwest cabin and the other as an addition to the
caretaker's cabin. In the years prior to 1939, with the consent of the board of
directors, four members, at their own expense, had each erected a cabin for his
own use, and in 1940 two members at their own expense each purchased and moved
onto the property an additional cabin.
Petitioner's purpose in acquiring its properties was to operate a private
fishing club thereon, with incidental rental of its properties for grazing
livestock. It has conducted these activities since the time of its
incorporation to date.
Petitioner's organization consists of twenty-five members, each owning twenty
shares of stock. It has a president, a vice president, a secretary-treasurer,
an assistant secretary, and a board of five directors. The members pay no dues,
but the stock is assessable. An annual assessment, with the exception of one or
two years, has been levied to cover expenses and amortization of loans.
The principal value of petitioner's lands to petitioner arose from the
fishing facilities offered by the Owens River as it flowed through and over
petitioner's land; but it also had some value for grazing purposes. The
property was not used for agricultural purposes, other than livestock grazing.
Aside from the receipt of the amount in controversy, the only sources of income
are, and have been, its receipts from guest card fees and its receipt of grazing
rentals. The amounts of guest card fees received by petitioner in the years
1939 to 1946, inclusive, and the amount of grazing rentals for the years 1936 to
1946, inclusive, are as follows:
Guest Grazing
Year fees rentals
1936 $ 300
1937 300
1938 300
1939 $ 330 300
1940 310 300
1941 130 550
1942 $ 105 $ 550
1943 145 1,000
1944 110 1,000
1945 275 1,000
1946 340 1,000
[*729] Each stockholder is entitled to the use of the properties for guests
for not exceeding eight guest days a season, and each day or fraction of a day a
guest uses the privileges of petitioner is counted as one guest day. The fee
collectible, either from the stockholder or the guest, is $ 5 per day.
Petitioner's rules regarding guests and guest card fees are designed to restrict
the number of guests and not to develop a source of revenue. The decline in
guest card fee receipts following 1939 was due in part to poor fishing on
account of increased flow and muddy water and, in later years, to gasoline
rationing. The increase in grazing rental following the year 1939 was not due
to any increase in grazing area or the number of grazing cattle, but to the fact
that higher prices for cattle and cattle fodder enabled petitioner to demand
higher grazing rentals, and for the year 1943 and subsequent years the leases
were revised to free the lessee from the requirement of maintaining two men to
keep poachers off petitioner's property.
The Department of Water and Power of the City of Los Angeles, a municipal
corporation, is responsible for the construction, operation, and maintenance of
the water supply of that city. On or about September 25, 1934, the Department
of Water and Power commenced the construction of Mono Craters Tunnel in Mono
County (the west portal of this tunnel being in Mono Basin and the east portal
being in the Owens River Drainage Basin.) On or about January 18, 1940, the
westerly aqueduct connecting this tunnel with Grant Lake Storage Reservoir was
completed. On or about April 4, 1940, the first diversion of Mono Basin waters
into the west portal of the tunnel was commenced. The east portal of the Mono
Craters Tunnel opens into the Owens River at a point approximately two miles up
the river from petitioner's property. In the operation of the Mono Craters
Tunnel the city of Los Angeles has stored waters in the Grant Lake Storage
Reservoir and Walker Lake, and natural storage has occurred in unregulated
lakes, all in the Mono Basin. The object of the tunnel project was, and the
result accomplished is, to divert waters which would naturally remain in the
Mono Basin into the Owens River at a point upstream from petitioner's lands.
These waters flow through or over petitioner's lands. The waters are recaptured
from the river by the city at a point below petitioner's lands and are diverted
into the water supply system of the city of Los Angeles. The waters flowing out
of or released from the east portal of the Mono Craters Tunnel are "foreign
waters" (that is, waters brought into the watershed from another source by
artificial means) with respect to the Owens River Drainage Basin, and would not
naturally flow into this river if it were not for the tunnel.
During the entire period of the construction of the Mono Craters Tunnel,
seepage waters from the tunnel in a substantial amount of between 10 and 15
cubic second feet flowed out of the east portal of [*730] the tunnel into
the Owens River and through and over petitioner's lands. These seepage waters
were polluted to a substantial extent by concrete dust, sediment, and foreign
matter, which injured and killed fish and interfered with the fishing on
petitioner's lands.
Prior to the settling of the rights of petitioner and the city of Los Angeles
by the execution of an indenture dated August 11, 1939, except as hereinafter
stated, the city was not possessed of, and had not acquired, either by way of
condemnation, prescription, user, grant or license, any right to divert,
release, or suffer the release of waters into the Owens River in such a manner
that such waters would flow through or over petitioner's lands, or to deposit or
permit the deposit of foreign matter in or to pollute the Owens River as it
flowed through petitioner's land; nor had the city compensated petitioner in
respect to these matters. Petitioner had not given the city any release or
acquittance with respect thereto, except for the period from November 12 to
December 2, 1935, when petitioner gave the city a revocable license to "dump"
waters into the river, and the city engineer was given permission to enter on
petitioner's lands for the purpose of making surveys.
Between September 25, 1934, the date the Mono Craters Tunnel project was
commenced, and August 11, 1939, petitioner and its attorneys complained to the
city and its officials concerning trespasses and invasions by the city and its
employees and against unauthorized fishing and poaching by city employees upon
petitioner's lands and rights. Petitioner threatened to institute injunctive
and other legal proceedings. After extended negotiations, petitioner and the
city entered into an arm's length agreement settling their differences on August
11, 1939. The indenture of August 11, 1939, after reciting that petitioner,
grantor, is the owner of certain described lands and that the city of Los
Angeles, as grantee, is constructing and intends to construct a tunnel known as
Mono Craters Tunnel, contains the further recital, covenants and provisions
material hereto, as follows:
(e) Whereas, a dispute has arisen between the parties hereto wherein Grantor
claims that it has been and is being damaged by reason of the discharge into
said Owens River, at a point upstream from Grantor's land, of foreign waters,
and that such damage will continue henceforth, and in a greater degree when said
tunnel is completed and in use, and said Grantor has threatened to sue for
damages and for an injunction, and the Grantee desires to obtain from Grantor
the right to discharge all such foreign water into said river in the future, and
the parties hereto are desirous of settling their differences, and for these
purposes the parties have executed, delivered and accepted this indenture for
the hereinafter mentioned consideration, rights and covenants.
I. For and in Consideration of the sum of Fifty Thousand Dollars ($
50,000.00), lawful money of the United States, paid by the Department of Water
and Power of The City of Los Angeles, receipt of which is hereby acknowledged by
Grantor, and of the covenants, conditions and promises on the part of Grantee
herein contained:
[*731] (A) The Grantor has released and forever discharged and by these
presents does for itself, its successors and assigns, release and forever
discharge The City of Los Angeles and the said Department of Water and Power of
said City of and from all manner of actions, causes of action, suits,
controversies, trespasses, damages, claims and demands whatsoever, in law or in
equity, which it now has, or ever had, or may have against said City and said
Department of Water and Power by reason of the discharging, releasing and
emptying of foreign waters from the easterly portal of the Mono Craters Tunnel
into the Owens River at a point upstream from Grantor's lands resulting in the
said waters flowing in and outside of the channel of the Owens River across and
over grantor's land, and by reason of discharging, releasing and emptying waters
from any and all other sources into said Owens River resulting in said waters
flowing in and outside of the channel of the Owens River across and over
Grantor's land and, further, by reason of any and all other acts of whatsoever
kind or nature of said Department, its employees, officers, or agents, upon, in
connection with or pertaining to Grantor's land, and any and all adjoining lands
owned by Grantor, and for all time up to and including the date of the execution
and delivery of this agreement, and its acceptance by Grantee.
(B) The Grantee, both for itself and for the Department of Water and Power of
The City of Los Angeles, has released and forever discharged and by these
presents does for itself, its successors and assigns, release and forever
discharge the Grantor of and from all manner of actions, causes of action,
suits, controversies, trespasses, damages, claims and demands whatsoever, in law
or in equity, which said City or said Department of Water and Power may have for
all time up to and including the date of the execution and delivery of this
agreement, and its acceptance by Grantee.
(C) The Grantor does hereby and by these presents grant, convey and transfer
unto the Grantee all those certain permanent and exclusive rights of way and
easements at any time and from time to time to convey all foreign waters into
the channel of the Owens River at a point therein near said easterly portal and
upstream from Grantor's land, over, through and across said lands by natural
gravity flow in the flood channel or channels of said Owens River and over,
through and across such other portions of Grantor's land as may be inundated and
overflowed at high stages of flow, without being materially diminished in
quantity or being materially impaired in quality by any act of Grantor, its
successors or assigns, for the purpose of being recaptured by Grantee and used
at any time or place of diversion downstream from said hereinafter described
lands; and said easement shall include the right so to convey said foreign
waters even though, when combined with the natural waters flowing in said Owens
River, they exceed the safe carrying capacity of said channel or channels of
said Owens River as it now exists or as said channel or channels hereafter may
exist upon said Grantor's lands, or damages or injuries [sic] said lands by
inundation, flooding, overflowing the existing channel or channels, cutting a
new channel or channels from time to time, silting, cutting, washing, raising
the underground water level or in any other manner whatsoever or at all.
Reserving unto Grantor, its successors and assigns, the following:
1. The right and privilege, at its own expense, of directing the flow of said
waters upon, over and across Grantor's lands and/or confining the area
overflowed by said foreign waters and natural waters by dredging, deepening,
cleaning out or straightening any existing channel of said Owens River, by
dredging an additional channel or channels on Grantor's lands or by any other
reasonable manner or method, provided that the same is consistent with good
engineering practice in the operation of Grantee's municipal water system and
does not [*732] interfere with the reasonable flowage of said discharged
waters upon, over, across and off of Grantor's lands.
2. All waters and water rights, riparian, appropriated or of whatsoever kind
or nature, now owned or possessed by Grantor.
3. The exclusive fishing, hunting and trapping rights and privileges in and
about all waters, both foreign and natural, flowing in said Owens River, its
branches, tributaries, flood waters and back waters, all rights to use said
lands for the purpose of agriculture, horticulture, bee-raising, farming,
ranching, raising and/or pasturing livestock, the erection or maintenance of
structures incidental or convenient thereto, the use of said lands for the
construction and maintenance of residential ranch or farm cabins or lodges, or
structures incidental thereto, provided that the same does not interfere with
the full, free and complete possession, use and enjoyment by grantee of all the
rights herein granted.
The grantee also covenants to perform certain other conditions regulating and
limiting the amount of water released by the grantee.
Petitioner expended in 1939 the sum of $ 1,055 for attorneys' fees and costs
in connection with the settlement with the city.
Under the indenture of August 11, 1939, the petitioner reserved substantial
beneficial interests in its properties and has continued to function and operate
as a fishing club, with incidental leasing out of its lands for grazing
livestock from the date of the indenture to the present time. The indenture
permits the city to release foreign waters into the Owens River in such
quantities that the total of the foreign and natural waters flowing into that
river as it enters petitioner's lands shall not exceed 400 cubic feet per
second. The Mono Craters Tunnel has a capacity of 365 cubic feet per second.
The natural flow of the Owens River as it enters petitioner's lands was not less
than 35 cubic feet per second for the years 1939 to 1946, inclusive. The
natural flow of the Owens River through petitioner's lands in terms of mean
annual cubic feet per second, and the highest daily average released from the
east portal of the Mono Craters Tunnel, are as follows:
Natural flow, Released from
Year feet per second tunnel, feet per
second
1939 55.8 20.
1940 45.9 110.9
1941 56.1 266.
1942 64.1 173.9
1943 61.3 169.5
1944 53.7 140.
1945 59.4 206.8
1946 60.3 19.8
The amounts of water released from the Mono Craters Tunnel into Owens River
in the years 1939 to date have resulted in substantial injury and damage to
petitioner and its properties in that (a) the quality and quantity of the fish
have been reduced; (b) grazing lands have been damaged and grazing fodder
reduced from 25 per cent to 35 per cent below its former quality and quantity;
(c) irrigation [*733] ditches and intake gates have been damaged,
necessitating repairs; (d) the river banks have been cut and undermined and the
character of the stream altered; and (e) the meadow lands have been flooded for
extended periods. Petitioner has been put to an expense of $ 13,800 in
constructing a diversion ditch in an attempt to control the waters flowing
through and over its property. It also expended $ 1,409.30 in 1939 and 1940 in
restocking the Owens River with some 50,000 small fry and some 3,000 full sized
fish in an attempt to replace fish destroyed by the Mono Craters Tunnel project.
Petitioner has not used and does not have need to use the Mono Craters Tunnel
waters or the diversion ditch for irrigation purposes.
The adjusted basis of petitioner's properties was more than $ 50,000 on
January 1, 1939. Disregarding the sum in controversy, no event occurred in 1939
which would cause or require the adjusted basis of these properties to be
reduced below $ 50,000 for the taxable year involved.
The petitioner's income and excess profits tax return for the taxable year
1939 did not report receipt of any income from the city of Los Angeles, but
included a schedule which reported receipt of $ 50,000 from the city in
connection with a certain written agreement and settlement of certain specified
matters, wherein expenses amounted to $ 1,055, and petitioner received a net
amount of $ 48,945. In his deficiency notice the respondent included the sum of
$ 48,945 as taxable income to petitioner under section 22 (a) of the Internal
Revenue Code.
OPINION.
The question presented is whether the net amount of $ 48,945 received by
petitioner in the taxable year 1939 under a certain indenture constitutes
taxable income under section 22 (a), or is chargeable to capital account. The
respondent contends: (a) That the $ 50,000, less $ 1,055 expenses incurred,
which petitioner received from the city of Los Angeles under the indenture of
August 11, 1939, represented compensation for loss of present and future income
and consideration for release of many meritorious causes of action against the
city, constituting ordinary income; and, (b) since petitioner has failed to
allocate such sum between taxable and nontaxable income, it has not sustained
its burden of showing error. Petitioner maintains that the language of the
indenture and the circumstances leading up to its execution demonstrate that the
consideration was paid for the easement granted to the city of Los Angeles and
the consequent damage to its property rights; that the loss of past or future
profits was not considered or involved; that the character of the easement
rendered it impracticable to attempt to apportion a basis to the property
affected; and, since the sum received is less than the basis of the entire
[*734] property, taxation should be postponed until the final disposition of
the property.
The recitals in the indenture of August 11, 1939, indicate its principal
purpose was to convey to the city of Los Angeles a right of way and perpetual
easements to discharge water upon and flood the lands of petitioner, in
connection with the water supply of the city. Among its covenants are
reciprocal releases by the respective parties. The respondent relies heavily on
the language of the release by petitioner as grantor, contained in paragraph (A)
of the indenture, which is set forth in full in our findings of fact. We think
the respondent places too much emphasis upon the release provision of the
indenture. It is usual and customary in agreements of this character to
incorporate a provision for the release and discharge of any possible past,
present, or future claims and demands. The mutuality of the releases indicates
the purpose was precautionary and protective rather than descriptive and in
recognition of asserted claims and demands. Paragraph (e) of the indenture
recites that "a dispute has arisen between the parties hereto wherein Grantor
claims that it has been and is being damaged by reason of the discharge into
said Owens River * * * of foreign waters, and that such damage will continue
henceforth * * *." The character of the damage is not specified or otherwise
indicated. The record reveals, through the testimony of petitioner's officers
and its attorneys who carried on the negotiations culminating in the agreement,
that no claim for damages for lost profits or income was ever asserted or
considered. Of primary concern was the fact that, if the city were permitted to
continue interference with petitioner's rights as riparian owner, the city might
acquire, by prescription or user, the right to direct foreign waters into the
Owens River, flooding petitioner's lands and interfering with its fishing rights
by polluting the stream. The threat of an injunction suit was to protect
petitioner against the city acquiring such rights without making proper
compensation therefor. The evidence does not disclose any claim for or loss of
income. There is some evidence that employees of the city, from time to time,
engaged in unauthorized fishing and poaching upon petitioner's lands. The
remedy of the petitioner for such wrongful acts would be against the individuals
and not against the municipality, since clearly such tortious acts were not
within the scope of their employment. Obviously, no part of the consideration
received by petitioner from the city was paid for the release of such claims and
demands. The recital in the indenture that petitioner, as grantor, released the
city from all claims and demands "by reason of any and all other acts of
whatsoever kind or nature of said Department, its employees, officers, or
agents, upon, in connection with or pertaining to Grantor's land" embraces such
acts as were within the scope of their employment. The record does not disclose
the existence of such acts, [*735] if there were any. No claims or demands
based on acts of that character had been made. We conclude that petitioner has
satisfactorily established that the $ 50,000 it received in 1939 was
consideration paid by the city for a right of way and easements and for
resulting damages to its property and property rights.
The respondent further contends that petitioner has failed to allocate any
portion of the $ 50,000 to nontaxable recovery of capital. He argues that the
payment was a "lump sum" settlement related to many things which were not
connected with petitioner's capital, such as loss of grazing rentals, guest card
fees, and loss of fish from pollution. The record establishes that the grazing
rentals were constant and that the guest fees were not intended to develop a
source of operating revenue, but merely to restrict the number of guests.
Pollution of the stream is an injury to property. The loss of fish as a result
of the pollution of the river could form no basis for a claim, since fish in
their wild state belong to the sovereign. In support of his position the
respondent relies upon Raytheon Production Corporation, 1 T. C. 952; affd., 144
Fed. (2d) 110; certiorari denied, 323 U.S. 779; R. J. Durkee, 6 T. C. 773; since
reversed, 162 Fed. (2d) 184. In the Durkee case, the Circuit Court says:
It is settled that since profits from business are taxable, a sum received in
settlement of litigation based upon a loss of profits is likewise taxable; but
where the settlement represents damages for lost capital rather than for lost
profits the money received is a return of capital and not taxable. * * *
[Citing many cases.] The difficulty is in determining whether the recovery is
for lost profits or for lost capital. The test is as stated by this Court in
Farmers' & Merchants' Bank v. Commissioner, supra, and approved in Swastika Oil
& Gas Company v. Commissioner, supra, namely, "The fund involved must be
considered in the light of the claim from which it was realized and which is
reflected in the petition filed."
Upon this record we have concluded that no part of the recovery was paid for
loss of profits, but was paid for the conveyance of a right of way and
easements, and for damages to petitioner's land and its property rights as
riparian owner. Hence, the respondent's contention has no merit. Capital
recoveries in excess of cost do constitute taxable income. Petitioner has made
no attempt to allocate a basis to that part of the property covered by the
easements. It is conceded that all of petitioner's lands were not affected by
the easements conveyed. Petitioner does not contest the rule that, where
property is acquired for a lump sum and subsequently disposed of a portion at a
time, there must be an allocation of the cost or other basis over the several
units and gain or loss computed on the disposition of each part, except where
apportionment would be wholly impracticable or impossible. Nathan Blum, 5 T. C.
702, 709. Petitioner argues that it would be impracticable and impossible to
apportion a definite basis to the easements here involved, since they could
not be described by [*736] metes and bounds; that the flow of the water has
changed and will change the course of the river; that the extent of the flood
was and is not predictable; and that to date the city has not released the full
measure of water to which it is entitled. In Strother v. Commissioner, 55 Fed.
(2d) 626, the court says:
* * * A taxpayer * * * should not be charged with gain on pure conjecture
unsupported by any foundation of ascertainable fact. See Burnet v. Logan, 283
U.S. 404; 51 S. Ct. 550, 75 L. Ed. 1143.
This rule is approved in the recent case of Raytheon Production Corporation
v. Commissioner, supra. Apportionment with reasonable accuracy of the amount
received not being possible, and this amount being less than petitioner's cost
basis for the property, it can not be determined that petitioner has, in fact,
realized gain in any amount. Applying the rule as above set out, no portion of
the payment in question should be considered as income, but the full amount must
be treated as a return of capital and applied in reduction of petitioner's cost
basis. Burnet v. Logan, 283 U.S. 404.
Decision will be entered for the petitioner.
WOODSAM ASSOCIATES, Inc. v. COMMISSIONER OF INTERNAL REVENUE
No. 195, Docket 22184
UNITED STATES COURT OF APPEALS SECOND CIRCUIT
198 F.2d 357; 1952 U.S. App. LEXIS 4137; 52-2 U.S. Tax Cas.
(CCH) P9396; 42 A.F.T.R. (P-H) 505; 1952 P.H. P72,536
July 8, 1952
OPINION: [*357]
The petitioner paid its income and declared value excess profits taxes for
1943 as computed upon returns it filed which included as part of its gross
income $ 146,058.10 as gain realized upon the mortgage foreclosure sale in that
year of improved real estate [*358] which it owned and which was bid in by
the mortgagee for a nominal sum. It filed a timely claim for refund on the
ground that its adjusted [**2] basis for the property had been understated
and its taxable gain, therefore, was less than that reported. The refund claim
was denied and a deficiency in both its income taxes and declared value excess
profits taxes was determined which was affirmed, without dissent, in a decision
reviewed by the entire Tax Court. The decisive issue now presented is whether
the basis for determining gain or loss upon the sale or other disposition of
property is increased when, subsequent to the acquisition of the property, the
owner receives a loan in an amount greater than his adjusted basis which is
secured by a mortgage on the property upon which he is not personally liable.
If so, it is agreed that part of the income taxes and all of the declared value
excess profits taxes paid for 1943 should be refunded.
A comparatively brief statement of the admitted facts and their obvious, and
conceded, tax consequences will suffice by way of introduction.
On December 29, 1934, Samuel J. Wood and his wife organized the petitioner
and each transferred to it certain property in return for one-half of its
capital stock. One piece of property so transferred by Mrs. Wood was the above
mentioned parcel of [**3] improved real estate consisting of land in the City
of New York and a brick building thereon divided into units suitable for use,
and used, in retail business. The property was subject to a $ 400,000 mortgage
on which Mrs. Wood was not personally liable and on which the petitioner never
became personally liable. Having, thus, acquired the property in a tax free
exchange, I.R.C. Sec. 112(b)(5), 26 U.S.C.A. @ 112(b)(5), the petitioner took
the basis of Mrs. Wood for tax purposes. I.R.C. Sec. 113(a)(8), 26 U.S.C.A. @
113(a) (8). Upon the final disposition of the property at the foreclosure sale
there was still due upon the mortgage the principal amount of $ 381,000 and, as
the petitioner concedes, n1 the extent to which the amount of the mortgage
exceeds its adjusted basis was income taxable to it even though it was not
personally liable upon the mortgage. Crane v. C.I.R., 331 U.S. 1, 67 S.Ct.
1047, 91 L.Ed. 1301.
Turning now to the one item whose effect upon the calculation of the
petitioner's adjusted basis is disputed, the following admitted facts need to be
stated. Mrs. Wood bought the property on January 20, 1922 at a total cost of $
296,400. She paid $ 101,400 in cash, [**4] took the title subject to an
existing mortgage for $ 120,000 and gave a purchase money bond and second
mortgage for $ 75,000. She had made payments on the first mortgage reducing it
to $ 112,500, when, on December 30, 1925, both of the mortgages were assigned to
the Title Guarantee and Trust Company. On January 4, 1926 Mrs. Wood borrowed $
137,500 from the Title Guarantee & Trust Company and gave it a bond and mortgage
for $ 325,000 on which she was personally liable, that being the amount of the
two existing mortgages, which were consolidated into the new one, plus the
amount of the cash borrowed. On June 9, 1931 this consolidated mortgage was
assigned to the East River Savings Bank and, shortly thereafter, Mrs. Wood
borrowed an additional $ 75,000 from that bank which she received upon the
execution of a second consolidated mortgage for $ 400,000 comprising the
principal amount due on the first consolidated mortgage plus the additional
loan. However, this transaction was carried out through the use of a 'dummy' so
that, under New York law, Mrs. Wood [*359] was not personally liable on this
bond and mortgage. See In re Childs Co., 2 Cir., 163 F.2d 379. This was the
mortgage, [**5] reduced as above stated, which was foreclosed.
The contention of the petitioner may now be stated quite simply. It is that,
when the borrowings of Mrs. Wood subsequent to her acquisition of the property
became charges solely upon the property itself, the cash she received for the
repayment of which she was not personally liable was a gain then taxable to her
as income to the extent that the mortgage indebtedness exceeded her adjusted
basis in the property. That being so, it is argued that her tax basis was,
under familiar principles of tax law, increased by the amount of such taxable
gain and that this stepped up basis carried over to the petitioner in the tax
free exchange by which it acquired the property.
While this conclusion would be sound if the premise on which it is based
were correct, we cannot accept the premise. It is that the petitioner's
transferor made a taxable disposition of the property, within the meaning of
I.R.C. Sec. 111(a), 26 U.S.C.A. @ 111(a), when the second consolidated mortgage
was executed, because she had, by then, dealt with it in such a way that she had
received cash, in excess of her basis, which, at that time, she was freed from
any personal [**6] obligation to repay. Nevertheless, whether or nor
personally liable on the mortgage, 'The mortgagee is a creditor, and in effect
nothing more than a preferred creditor, even though the mortgagor is not liable
for the debt. He is not the less a creditor because he has recourse only to the
land, unless we are to deny the term to one who may levy upon only a part of his
debtor's assets.' C.I.R. v. Crane, 2 Cir., 153 F.2d 504, 506. Mrs. Wood merely
augmented the existing mortgage indebtedness when she borrowed each time and,
far from closing the venture, remained in a position to borrow more if and when
circumstances permitted and she so desired. And so, she never 'disposed' of the
property to create a taxable event which Sec. 111(a) I.R.C. makes a condition
precedent to the taxation of gain. 'Disposition,' within the meaning of Sec.
111(a), is the "getting rid, or making over, of anything; relinquishment".
Herber's Estate v. Commissioner, 3 Cir., 139 F.2d 756, 758, certiorari denied
322 U.S. 752, 64 S.Ct. 1263, 88 L.Ed. 1582. Nothing of that nature was done here
by the mere execution of the second consolidated mortgage; Mrs. Wood was the
owner of this property in the same sense after [**7] the execution of this
mortgage that she was before. As was pointed out in our decision in the Crane
case, supra, 153 F.2d at 505-506, ' * * * the lien of a mortgage does not make
the mortgagee a cotenant; the mortgagor is the owner for all purposes; indeed
that is why the 'gage' is 'mort,' as distinguished from a 'vivum vadium.'
Kortright v. Cady, 21 N.Y. 343, 344, 78 Am.Dec. 145. He has all the income from
the property; he manages it; he may sell it; any increase in its value goes to
him; any decrease falls on him, until the value goes below the amount of the
lien.' Realization of gain was, therefore, postponed for taxation until there
was a final disposition of the property at the time of the foreclosure sale.
See Lutz & Schramm Co., 1 T.C. 682; Mendham Corp., 9 TOC. 320. Therefore, Mrs.
Wood's borrowings did not change the basis for the computation of gain or loss.
Affirmed.
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n1. The petitioner requested a finding that the value of the property was
less than the principal amount due on the mortgage which, it was apparently
urged, prevented it from realizing the full amount due thereon. The authority
cited was footnote 37 in Crane v. Commissioner, 331 U.S. 1, 67 S.Ct. 1047, 1054,
91 L.Ed. 1301, where the Court said, 'Obviously, if the value of the property is
less than the amount of the mortgage, a mortgagor who is not personally liable
cannot realize a benefit equal to the mortgage. Consequently, a different
problem might be encountered where a mortgagor abandoned the property or
transferred it subject to the mortgage without receiving boot. * * * ' However,
the petitioner has disclaimed reliance upon that and, we think, advisedly so.
Cf. Parker v. Delaney, 1 Cir., 186 F.2d 455.
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
COTTAGE SAVINGS ASSOCIATION v. COMMISSIONER OF INTERNAL
REVENUE
No. 89-1965
SUPREME COURT OF THE UNITED STATES
499 U.S. 554; 111 S. Ct. 1503; 1991 U.S. LEXIS 2224; 113 L.
Ed. 2d 589; 59 U.S.L.W. 4314; 91-1 U.S. Tax Cas. (CCH)
P50,187; 67 A.F.T.R.2d (RIA) 808; 91 Cal. Daily Op. Service
2736; 91 Daily Journal DAR 4403
SYLLABUS: Petitioner Cottage Savings Association simultaneously sold
participation interests in 252 mortgages to four savings and loan associations
and purchased from them participation interests in 305 other mortgages. All of
the loans were secured by single-family homes. The fair market value of the
package of participation interests exchanged by each side was approximately $
4.5 million. The face value of the participation interests relinquished by
Cottage Savings was $ 6.9 million. For Federal Home Loan Bank Board (FHLBB)
accounting purposes, Cottage Savings' mortgages were treated as having been
exchanged for "substantially identical" ones held by the other lenders. On its
1980 federal income tax return, Cottage Savings claimed a deduction for the
adjusted difference between the face value of the interests it traded and the
fair market value of the interests it received. Following the Commissioner's
disallowance of the deduction, the Tax Court determined the deduction was
pemissible. The Court of Appeals reversed, finding that Cottage Savings had
[***2] realized its losses through the transaction, but that it was not
entitled to a deduction because its losses were not actually sustained for
purposes of @ 165(a) of the Internal Revenue Code, which allows deductions only
for bona fide losses.
Held:
1. Cottage Savings realized a tax-deductible loss because the properties it
exchanged were materially different. Pp. 559-567.
(a) In order to avoid the cumbersome, abrasive, and unpredictable
administrative task of valuing assets annually to determine whether their value
has appreciated or depreciated, @ 1001(a) of the Code defers the tax
consequences of a gain or loss in property until it is realized through the
"sale or disposition of [the] property." This rule serves administrative
convenience because a change in the investment's form or extent can be easily
detected by a taxpayer or an administrative officer. P. 559.
(b) An exchange of property constitutes a "disposition of property" under @
1001(a) only if the properties exchanged are materially different. Although the
statute and its legislative history are silent on the subject, Treasury
Regulation @ 1.1001-1 includes a material difference requirement for realization
to [***3] occur through a disposition of property. Treasury Regulation @
1.1001-1 should be given deference as a reasonable interpretation of @ 1001(a).
Where, as here, a Treasury Regulation long continues without substantial change
and applies to a substantially reenacted statute, it is deemed to have
congressional approval. The regulation is also consistent with this Court's
landmark precedents on realization, which make clear that a taxpayer realizes
taxable income only if the properties exchanged are "materially" or
"essentially" different. United States v. Phellis, 257 U.S. 156, 173; Weiss v.
Stearn, 265 U.S. 242, 253-254; Marr v. United States, 268 U.S. 536, 540-542.
Since these cases were part of the contemporary legal context in which the
substance of @ 1001(a) was originally enacted, and since Congress has left their
principles undisturbed through subsequent reenactments, it can be presumed that
Congress intended to codify these principles in @ 1001(a). Pp. 560-562.
(c) Properties are materially different if their respective possessors enjoy
legal entitlements that are different [***4] in kind or extent. As long as
the property entitlements are not identical, their exchange will allow both the
Commissioner and the transacting taxpayer to fix the appreciated or depreciated
values of the property relative to their tax bases. There is no support in
Phellis, Weiss, or Marr for the Commissioner's "economic substitute" concept of
material difference, under which differences would be material only when the
parties, the relevant market, and the relevant regulatory body would consider
them so. Moreover, the complexity of the Commissioner's approach both ill
serves the goal of administrative convenience underlying the realization
requirement and is incompatible with the Code's structure. Pp. 562-566.
(d) Cottage Savings' transactions easily satisfy the material difference
test. Since the participation interests exchanged derived from loans that were
made to different obligors and secured by different homes, the exchanged
interests embodied legally distinct entitlements. Thus, Cottage Savings
realized its losses at the point of the exchange, at which time both it and the
Commissioner were in a position to determine the change in the value of its
mortgages relative [***5] to their tax bases. The mortgages' status under
the FHLBB's criteria has no bearing on this conclusion, since a mortgage can be
"substantially identical" to the FHLBB and still exhibit "differences" that are
"material" for purposes of the Code. Pp. 566-567.
2. Cottage Savings sustained its losses within the meaning of @ 165(a) of
the Code. The Commissioner's apparent argument that the losses were not bona
fide is rejected, since there is no contention that the transaction was not
conducted at arm's length or that Cottage Savings retained de facto ownership of
the participation interests it traded. Higgins v. Smith, 308 U.S. 473,
distinguished. Pp. 567-568.
JUDGES: Marshall, J., delivered the opinion of the Court, in which Rehnquist,
C.J., and Stevens, O'Connor, Scalia, Kennedy, and Souter, JJ., joined.
Blackmun, J., filed a dissenting [***6] opinion, in which White, J.,joined,
post, p. 568.
OPINIONBY: MARSHALL
OPINION: [*556] [**1506] The issue in this case is whether a financial
institution realizes tax-deductible losses when it exchanges its interests in
one group of residential mortgage loans for another lender's interests in a
different group of residential mortgage loans. We hold that such a transaction
does give rise to realized losses.
I
Petitioner Cottage Savings Association (Cottage Savings) is a savings and
loan association (S & L) formerly regulated by the Federal Home Loan Bank Board
(FHLBB). n1 Like many S & L's, Cottage Savings held numerous long-term,
low-interest mortgages that declined in value when interest rates surged in the
late 1970's. These institutions would have benefited from selling their
devalued mortgages in order to realize tax-deductible losses. However, they
were deterred from doing so by FHLBB accounting regulations, which required them
to record the losses on their books. [*557] Reporting these losses
consistent with the then-effective FHLBB accounting regulations would have
placed many S & L's at risk of closure by the FHLBB.
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n1 Congress abolished the FHLBB in 1989. See @ 401 of the Financial
Institutions Reform, Recovery, and Enforcement Act of 1989, Pub. L. 101-73, 103
Stat. 354.
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[***7]
The FHLBB responded to this situation by relaxing its requirements for the
reporting of losses. In a regulatory directive known as "Memorandum R-49,"
dated June 27, 1980, the FHLBB determined that S & L's need not report losses
associated with mortgages that are exchanged for "substantially identical"
mortgages held by other lenders. n2 The FHLBB's acknowledged purpose for
Memorandum R-49 was to facilitate transactions that would generate tax losses
but that would not substantially affect the economic position of the transacting
S & L's.
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n2 Memorandum R-49 listed 10 criteria for classifying mortgages as
substantially identical.
"The loans involved must:
"1. involve single-family residential mortgages,
"2. be of similar type (e. g., conventionals for conventionals),
"3. have the same stated terms to maturity (e. g., 30 years),
"4. have identical stated interest rates,
"5. have similar seasoning (i. e., remaining terms to maturity),
"6. have aggregate principal amounts within the lesser of 2 1/2% or $
100,000 (plus or minus) on both sides of the transaction, with any additional
consideration being paid in cash,
"7. be sold without recourse,
"8. have similar fair market values,
"9. have similar loan-to-value ratios at the time of the reciprocal sale,
and
"10. have all security properties for both sides of the transaction in the
same state." Record, Exh. 72-BT.
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[***8]
This case involves a typical Memorandum R-49 transaction. On December 31,
1980, Cottage Savings sold "90% participation interests" in 252 mortgages to
four S & L's. It simultaneously purchased "90% participation interests" in 305
mortgages held by these S & L's. n3 All of the loans involved [*558] in the
transaction were secured by single-family homes, most in the Cincinnati area.
The fair market value of the package of participation interests exchanged by
each side was approximately $ 4.5 million. The face value of the participation
interests Cottage Savings relinquished in the transaction was approximately $
6.9 million. See 90 T. C. 372, 378-382 (1988).
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n3 By exchanging merely participation interests rather than the loans
themselves, each party retained its relationship with the individual obligors.
Consequently, each S & L continued to service the loans on which it had
transferred the participation interests and made monthly payments to the
participation-interest holders. See 90 T. C. 372, 381 (1988).
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
[***9]
On its 1980 federal income tax return, Cottage Savings claimed a deduction
for $ 2,447,091, which represented the adjusted difference between the face
value of the participation interests that it traded and the fair market value of
the participation interests that it received. As permitted by Memorandum
[**1507] R-49, Cottage Savings did not report these losses to the FHLBB.
After the Commissioner of Internal Revenue disallowed Cottage Savings' claimed
deduction, Cottage Savings sought a redetermination in the Tax Court. The Tax
Court held that the deduction was permissible. See 90 T. C. 372 (1988).
On appeal by the Commissioner, the Court of Appeals reversed. 890 F. 2d 848
(CA6 1989). The Court of Appeals agreed with the Tax Court's determination that
Cottage Savings had realized its losses through the transaction. See id., at
852. However, the court held that Cottage Savings was not entitled to a
deduction because its losses were not "actually" sustained during the 1980 tax
year for purposes of 26 U. S. C. @ 165(a). See 890 F. 2d, at 855. [***10]
Because of the importance of this issue to the S & L industry and the
conflict among the Circuits over whether Memorandum R-49 exchanges produce
deductible tax losses, n4 we granted certiorari. 498 U.S. 808 (1990). We now
reverse.
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n4 The two other Courts of Appeals that have considered the tax treatment of
Memorandum R-49 transactions have found that these transactions do give rise to
deductible losses. See Federal Nat. Mortgage Assn. v. Commissioner, 283 U.S.
App. D. C. 53, 56-58, 896 F. 2d 580, 583-584 (1990); San Antonio Savings Assn.
v. Commissioner, 887 F. 2d 577 (CA5 1989).
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[*559] II
Rather than assessing tax liability on the basis of annual fluctuations in
the value of a taxpayer's property, the Internal Revenue Code defers the tax
consequences of a gain or loss in property value until the taxpayer "realizes"
the gain or loss. The realization requirement is implicit in @ 1001(a) of the
Code, 26 U. S. C. @ 1001(a), which defines [***11] "the gain [or loss] from
the sale or other disposition of property" as the difference between "the amount
realized" from the sale or disposition of the property and its "adjusted basis."
As this Court has recognized, the concept of realization is "founded on
administrative convenience." Helvering v. Horst, 311 U.S. 112, 116 (1940). Under
an appreciation-based system of taxation, taxpayers and the Commissioner would
have to undertake the "cumbersome, abrasive, and unpredictable administrative
task" of valuing assets on an annual basis to determine whether the assets had
appreciated or depreciated in value. See 1 B. Bittker & L. Lokken, Federal
Taxation of Income, Estates and Gifts P 5.2, p. 5-16 (2d ed. 1989). In
contrast, "[a] change in the form or extent of an investment is easily detected
by a taxpayer or an administrative officer." R. Magill, Taxable Income 79 (rev.
ed. 1945).
Section 1001(a)'s language provides a straightforward test for realization:
to realize a gain or loss in the value of property, the taxpayer must engage in
a "sale or other disposition of [the] property." The parties agree that the
exchange of participation [***12] interests in this case cannot be
characterized as a "sale" under @ 1001(a); the issue before us is whether the
transaction constitutes a "disposition of property." The Commissioner argues
that an exchange of property can be treated as a "disposition" under @ 1001(a)
only if the properties exchanged are materially different. The Commissioner
further submits that, because the underlying mortgages [*560] were
essentially economic substitutes, the participation interests exchanged by
Cottage Savings were not materially different from those received from the other
S & L's. Cottage Savings, on the other hand, maintains that any exchange of
property is a "disposition of property" under @ 1001(a), regardless of whether
the property exchanged is materially different. Alternatively, Cottage Savings
contends that the participation interests exchanged were materially different
because the underlying loans were secured by different properties.
We must therefore determine whether the realization principle in @ 1001(a)
incorporates a "material difference" requirement. If it [**1508] does, we
must further decide what that requirement amounts to and how it applies in this
case. We consider these [***13] questions in turn.
A
Neither the language nor the history of the Code indicates whether and to
what extent property exchanged must differ to count as a "disposition of
property" under @ 1001(a). Nonetheless, we readily agree with the Commissioner
that an exchange of property gives rise to a realization event under @ 1001(a)
only if the properties exchanged are "materially different." The Commissioner
himself has by regulation construed @ 1001(a) to embody a material difference
requirement:
"Except as otherwise provided . . . the gain or loss realized from the
conversion of property into cash, or from the exchange of property for other
property differing materially either in kind or in extent, is treated as income
or as loss sustained." Treas. Reg. @ 1.1001-1, 26 CFR @ 1.1001-1 (1990)
(emphasis added).
Because Congress has delegated to the Commissioner the power to promulgate "all
needful rules and regulations for the enforcement of [the Internal Revenue
Code]," 26 U. S. C. @ 7805(a), we must defer to his regulatory interpretations
[*561] of the Code so long as they are reasonable, see National Muffler
Dealers Assn., Inc. v. United States, 440 U.S. 472, 476-477 (1979). [***14]
We conclude that Treasury Regulations @ 1.1001-1 is a reasonable
interpretation of @ 1001(a). Congress first employed the language that now
comprises @ 1001(a) of the Code in @ 202(a) of the Revenue Act of 1924, ch. 234,
43 Stat. 253; that language has remained essentially unchanged through various
reenactments. n5 And since 1934, the Commissioner has construed the statutory
term "disposition of property" to include a "material difference" requirement.
n6 As we have recognized, "'Treasury regulations and interpretations long
continued without substantial change, applying to unamended or substantially
reenacted statutes, are deemed to have received congressional approval and have
the effect of law.'" United States v. Correll, 389 U.S. 299, 305-306 (1967),
quoting Helvering v. Winmill, 305 U.S. 79, 83 (1938).
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n5 Section 202(a) of the 1924 Act provided:
"Except as hereinafter provided in this section, the gain from the sale or
other disposition of property shall be the excess of the amount realized
therefrom over the basis provided in subdivision (a) or (b) of section 204, and
the loss shall be the excess of such basis over the amount realized."
The essence of this provision was reenacted in @ 111(a) of Revenue Act of
1934, ch. 277, 48 Stat. 703; and then in @ 111(a) of the Internal Revenue Code
of 1939, ch. 1, 53 Stat. 37; and finally in @ 1001(a) of the Internal Revenue
Code of 1954, Pub. L. 591, 68A Stat. 295. [***15]
n6 What is now Treas. Reg. @ 1.1001-1 originated as Treas. Reg. 86, Art.
111-1, which was promulgated pursuant to the Revenue Act of 1934. That
regulation provided:
"Except as otherwise provided, the Act regards as income or as loss
sustained, the gain or loss realized from the conversion of property into cash,
or from the exchange of property for other property differing materially either
in kind or in extent" (emphasis added).
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
Treasury Regulation @ 1.001-1 is also consistent with our landmark precedents
on realization. In a series of early decisions involving the tax effects of
property exchanges, this Court made clear that a taxpayer realizes taxable
income [*562] only if the properties exchanged are "materially" or
"essentially" different. See United States v. Phellis, 257 U.S. 156, 173
(1921); Weiss v. Stearn, 265 U.S. 242, 253-254 (1924); Marr v. United States,
268 U.S. 536, 540-542 (1925); see also Eisner v. Macomber, 252 U.S. 189, 207-212
(1920) [***16] (recognizing realization requirement). Because these
decisions were part of the "contemporary legal context" in which Congress
enacted @ 202(a) of the 1924 Act, see Cannon v. University of Chicago,
[**1509] 441 U.S. 677, 698-699 (1979), and because Congress has left
undisturbed through subsequent reenactments of the Code the principles of
realization established in these cases, we may presume that Congress intended to
codify these principles in @ 1001(a), see Pierce v. Underwood, 487 U.S. 552, 567
(1988); Lorillard v. Pons, 434 U.S. 575, 580-581 (1978). The Commissioner's
construction of the statutory language to incorporate these principles certainly
was reasonable.
B
Precisely what constitutes a "material difference" for purposes of @ 1001(a)
of the Code is a more complicated question. The Commissioner argues that
properties are "materially different" only if they differ in economic substance.
To determine whether the participation interests exchanged in this case were
"materially different" in this sense, the Commissioner argues, we should look to
the attitudes of the [***17] parties, the evaluation of the interests by the
secondary mortgage market, and the views of the FHLBB. We conclude that @
1001(a) embodies a much less demanding and less complex test.
Unlike the question whether @ 1001(a) contains a material difference
requirement, the question of what constitutes a material difference is not one
on which we can defer to the Commissioner. For the Commissioner has not issued
an authoritative, prelitigation interpretation of what property [*563]
exchanges satisfy this requirement. n7 Thus, to give meaning to the material
difference test, we must look to the case law from which the test derives and
which we believe Congress intended to codify in enacting and reenacting the
language that now comprises @ 1001(a). See Lorillard v. Pons, supra, at
580-581.
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n7 In its brief in United States v. Centennial Savings Bank FSB, No. 89-1926,
the Commissioner cites two Revenue Rulings that support the position that
mortgages exchanged through reciprocal mortgage sales are not materially
different. See Brief for United States 25, n. 21 (citingRev. Rul. 85-125,
1985-2 Cum. Bull. 180;Rev. Rul. 81-204, 1981-2 Cum. Bull. 157). Perhaps because
the two Revenue Rulings postdate the reciprocal mortgage exchange transaction at
issue here and do not purport to define the "differ materially" language in
Treasury Regulation @ 1.1001-1, the Commissioner has not argued that the
position taken in these rulings is entitled to deference. Compare, e. g.,
National Muffler Dealers Assn., Inc. v. United States, 440 U.S. 472, 483-484,
and nn. 16-19 (1979) (deferring to position reflected in longstanding series of
Revenue Rulings consistently adhering to same position in a variety of fact
patterns). See generally Udall v. Tallman, 380 U.S. 1, 16-17 (1965) (agency's
reasonable interpretation of its own regulations is entitled to deference).
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
[***18]
We start with the classic treatment of realization in Eisner v. Macomber,
supra. In Macomber, a taxpayer who owned 2,200 shares of stock in a company
received another 1,100 shares from the company as part of a pro rata stock
dividend meant to reflect the company's growth in value. At issue was whether
the stock dividend constituted taxable income. We held that it did not, because
no gain was realized. See id., at 207-212. We reasoned that the stock dividend
merely reflected the increased worth of the taxpayer's stock, see id., at
211-212, and that a taxpayer realizes increased worth of property only by
receiving "something of exchangeable value proceeding from the property," see
id., at 207.
In three subsequent decisions -- United States v. Phellis, supra; Weiss v.
Stearn, supra; and Marr v. United States, supra -- we refined Macomber's
conception of realization in the context of property exchanges. In each case,
the taxpayer owned stock [***19] that had appreciated in value since its
acquisition. [*564] And in each case, the corporation in which the taxpayer
held stock had reorganized into a new corporation, with the new corporation
assuming the business of the old [**1510] corporation. While the
corporations in Phellis and Marr both changed from New Jersey to Delaware
corporations, the original and successor corporations in Weiss both were
incorporated in Ohio. In each case, following the reorganization, the
stockholders of the old corporation received shares in the new corporation equal
to their proportional interest in the old corporation.
The question in these cases was whether the taxpayers realized the
accumulated gain in their shares in the old corporation when they received in
return for those shares stock representing an equivalent proportional interest
in the new corporations. In Phellis and Marr, we held that the transactions
were realization events. We reasoned that because a company incorporated in one
State has "different rights and powers" from one incorporated in a different
State, the taxpayers in Phellis and Marr acquired through the transactions
property that was "materially [***20] different" from what they previously
had. United States v. Phellis, 257 U.S., at 169-173; see Marr v. United
States, supra, at 540-542 (using phrase "essentially different"). In contrast,
we held that no realization occurred in Weiss. By exchanging stock in the
predecessor corporation for stock in the newly reorganized corporation, the
taxpayer did not receive "a thing really different from what he therefore had."
Weiss v. Stearn, supra, at 254. As we explained in Marr, our determination that
the reorganized company in Weiss was not "really different" from its predecessor
turned on the fact that both companies were incorporated in the same State. See
Marr v. United States, supra, at 540-542 (outlining distinction between these
cases).
Obviously, the distinction in Phellis and Marr that made the stock in the
successor corporations materially different from the stock in the predecessors
was minimal. Taken together, [*565] Phellis, Marr, and Weiss stand for the
principle that properties are "different" in the [***21] sense that is
"material" to the Internal Revenue Code so long as their respective possessors
enjoy legal entitlements that are different in kind or extent. Thus, separate
groups of stock are not materially different if they confer "the same
proportional interest of the same character in the same corporation." Marr v.
United States, 268 U.S., at 540. However, they are materially different if they
are issued by different corporations, id., at 541; United States v. Phellis,
supra, at 173, or if they confer "different rights and powers" in the same
corporation, Marr v. United States, supra, at 541. No more demanding a standard
than this is necessary in order to satisfy the administrative purposes
underlying the realization requirement in @ 1001(a). See Helvering v. Horst,
311 U.S., at 116. For, as long as the property entitlements are not identical,
their exchange will allow both the Commissioner and the transacting taxpayer
easily to fix the appreciated or depreciated values of the property relative to
their [***22] tax bases.
In contrast, we find no support for the Commissioner's "economic substitute"
conception of material difference. According to the Commissioner, differences
between properties are material for purposes of the Code only when it can be
said that the parties, the relevant market (in this case the secondary mortgage
market), and the relevant regulatory body (in this case the FHLBB) would
consider them material. Nothing in Phellis, Weiss, and Marr suggests that
exchanges of properties must satisfy such a subjective test to trigger
realization of a gain or loss.
Moreover, the complexity of the Commissioner's approach ill serves the goal
of administrative convenience that underlies the realization requirement. In
order to apply the Commissioner's test in a principled fashion, the Commissioner
and the taxpayer must identify the relevant market, establish [**1511]
whether there is a regulatory agency whose views should be taken into account,
and then assess how the relevant market [*566] participants and the agency
would view the transaction. The Commissioner's failure to explain how these
inquiries should be conducted further calls into question the workability
[***23] of his test.
Finally, the Commissioner's test is incompatible with the structure of the
Code. Section 1001(c) of Title 26 provides that a gain or loss realized under @
1001(a) "shall be recognized" unless one of the Code's nonrecognition provisions
applies. One such nonrecognition provision withholds recognition of a gain or
loss realized from an exchange of properties that would appear to be economic
substitutes under the Commissioner's material difference test. This provision,
commonly known as the "like kind" exception, withholds recognition of
a gain or loss realized "on the exchange of property held for productive use in
a trade or business or for investment . . . for property of like kind which is
to be held either for productive use in a trade or business or for investment."
26 U. S. C. @ 1031(a)(1). If Congress had expected that exchanges of similar
properties would not count as realization events under @ 1001(a), it would have
had no reason to bar recognition of a gain or loss realized from these
transactions.
C
Under our interpretation of @ 1001(a), an exchange of property gives rise to
a realization event so long as the exchanged [***24] properties are
"materially different" -- that is, so long as they embody legally distinct
entitlements. Cottage Savings' transactions at issue here easily satisfy this
test. Because the participation interests exchanged by Cottage Savings and the
other S & L's derived from loans that were made to different obligors and
secured by different homes, the exchanged interests did embody legally distinct
entitlements. Consequently, we conclude that Cottage Savings realized its
losses at the point of the exchange.
The Commissioner contends that it is anomalous to treat mortgages deemed to
be "substantially identical" by the [*567] FHLBB as "materially different."
The anomaly, however, is merely semantic; mortgages can be substantially
identical for Memorandum R-49 purposes and still exhibit "differences" that are
"material" for purposes of the Internal Revenue Code. Because Cottage Savings
received entitlements different from those it gave up, the exchange put both
Cottage Savings and the Commissioner in a position to determine the change in
the value of Cottage Savings' mortgages relative to their tax bases. Thus,
there is no reason not to treat the exchange of these interests as [***25] a
realization event, regardless of the status of the mortgages under the criteria
of Memorandum R-49.
III
Although the Court of Appeals found that Cottage Savings' losses were
realized, it disallowed them on the ground that they were not sustained under @
165(a) of the Code, 26 U. S. C. @ 165(a). Section 165(a) states that a
deduction shall be allowed for "any loss sustained during the taxable year and
not compensated for by insurance or otherwise." Under the Commissioner's
interpretation of @ 165(a),
"To be allowable as a deduction under section 165(a), a loss must be
evidenced by closed and completed transactions, fixed by identifiable events,
and, except as otherwise provided in section 165(h) and @ 1.165-11, relating to
disaster losses, actually sustained during the taxable year. Only a bona fide
loss is allowable. Substance and not mere form shall govern in determining a
deductible loss." Treas. Reg. @ 1.165-1(b), 26 CFR @ 1.165-1(b) (1990).
The Commissioner offers a minimal defense of the Court of Appeals'
conclusion. The Commissioner contends that the losses were not sustained
because they lacked "economic [**1512] substance," [***26] by which the
Commissioner seems to mean that the losses were not bona fide. We say "seems"
because the Commissioner states the position in one sentence in a footnote
[*568] in his brief without offering further explanation. See Brief for
Respondent 34-35, n. 39. The only authority the Commissioner cites for this
argument is Higgins v. Smith, 308 U.S. 473 (1939). See Brief for United States
in No. 89-1926, p. 16, n. 11.
In Higgins, we held that a taxpayer did not sustain a loss by selling
securities below cost to a corporation in which he was the sole shareholder. We
found that the losses were not bona fide because the transaction was not
conducted at arm's length and because the taxpayer retained the benefit of the
securities through his wholly owned corporation. See Higgins v. Smith, supra,
at 475-476. Because there is no contention that the transactions in this case
were not conducted at arm's length, or that Cottage Savings retained de facto
ownership of the participation interests it traded to the four reciprocating S &
L's, Higgins is inapposite. In view of the Commissioner's failure [***27] to
advance any other arguments in support of the Court of Appeals' ruling with
respect to @ 165(a), we conclude that, for purposes of this case, Cottage
Savings sustained its losses within the meaning of @ 165(a).
IV
For the reasons set forth above, the judgment of the Court of Appeals is
reversed, and the case is remanded for further proceedings consistent with this
opinion.
So ordered.
CONCURBY: BLACKMUN (No. 89-1926, In Part)
DISSENTBY: BLACKMUN (No. 89-1926, In Part)
DISSENT: Justice Blackmun, with whom Justice White joins, concurring in part
and dissenting in part in No. 89-1926, post, p. 573, and dissenting in No.
89-1965.
I agree that the early withdrawal penalties collected by Centennial Savings
Bank FSB do not constitute "income by reason of the discharge . . . of
indebtedness of the taxpayer," within the meaning of 26 U. S. C. @ 108(a)(1)
(1982 ed.), and that the penalty amounts are not excludable from Centennial's
gross income. I therefore join Part III of the Court's opinion in No. 89-1926.
[*569] I dissent, however, from the Court's conclusions in these two cases
that Centennial and Cottage Savings Association realized deductible losses
[***28] for income tax purposes when each exchanged partial interests in one
group of residential mortgage loans for partial interests in another like group
of residential mortgage loans. I regard these losses as not recognizable for
income tax purposes because the mortgage packages so exchanged were
substantially identical and were not materially different.
The exchanges, as the Court acknowledges, were occasioned by Memorandum R-49,
Record, Exh. 72-BT, issued by the Federal Home Loan Bank Board (FHLBB) on June
27, 1980, and by that Memorandum's relaxation of theretofore-existing accounting
regulations and requirements, a relaxation effected to avoid placement of "many
S & L's at risk of closure by the FHLBB" without substantially affecting the
"economic position of the transacting S & L's." Ante, at 557. But the
Memorandum, the Court notes, also had as a purpose the "facilitation of
transactions that would generate tax losses." Ibid. I find it somewhat
surprising that an agency not responsible for tax matters would presume to
dictate what is or is not a deductible loss for federal income tax purposes. I
had thought that that was something within the exclusive province of the
[***29] Internal Revenue Service, subject to administrative and judicial
review. Certainly, the FHLBB's opinion in this respect is entitled to no
deference whatsoever. See United States v. Stewart, 311 U.S. 60, 70 (1940);
Graff v. Commissioner, 673 F. 2d 784, 786 (CA5 1982) (concurring opinion). The
Commissioner, of course, took the opposing position. SeeRev. Rul. 85-125,
1985-2 Cum. Bull. 180;Rev. Rul. 81-204, 1981-2 Cum. Bull. 157.
It long has been established that gain or loss in the value of property is
taken into account for income tax purposes only if and when the gain or loss is
"realized," that is, when it is tied to a realization event, such as the sale,
exchange, or other disposition of the property. Mere variation in value --
[*570] the routine ups and downs of the marketplace -- do not in themselves
have income tax consequences. This is fundamental in income tax law.
In applying the realization requirement to an exchange, the properties
involved must be materially different in kind or in extent. Treas. [***30]
Reg. @ 1.1001-1(a), 26 CFR @ 1.10011(a) (1990). This has been the rule
recognized administratively at least since 1935, see Treas. Regs. 86, Art.
111-1, issued under the Revenue Act of 1934, and by judicial decision. See, e.
g., Mutual Loan & Savings Co. v. Commissioner, 184 F. 2d 161 (CA5 1950). See
also Marr v. United States, 268 U.S. 536, 541 (1925); Weiss v. Stearn, 265 U.S.
242, 254 (1924); United States v. Phellis, 257 U.S. 156 (1921). This makes
economic as well as tax sense, for the parties obviously regard the exchanged
properties as having equivalent values. In tax law, we should remember,
substance rather than form determines tax consequences. Commissioner v. Court
Holding Co., 324 U.S. 331, 334 (1945); Gregory v. Helvering, 293 U.S. 465,
469-470 (1935); Shoenberg v. Commissioner, 77 F. 2d 446, 449 (CA8), cert.
denied, 296 U.S. 586 (1935). Thus, the resolution of the exchange issue in these
cases [***31] turns on the "materially different" concept. The Court
recognizes as much. Ante, at 559-560.
That the mortgage participation partial interests exchanged in these cases
were "different" is not in dispute. The materiality prong is the focus. A
material difference is one that has the capacity to influence a decision. See,
e. g., Kungys v. United States, 485 U.S. 759, 770-771 (1988); Basic Inc. v.
Levinson, 485 U.S. 224, 240 (1988); TSC Industries, Inc. v. Northway, Inc., 426
U.S. 438, 449 (1976).
The application of this standard leads, it seems to me, to only one answer --
that the mortgage participation partial interests released were not materially
different from the mortgage participation partial interests received.
Memorandum R-49, as the Court notes, ante, at 557, n. 2, lists 10 factors that,
when satisfied, as they were here, serve to classify the [*571] interests as
"substantially identical." These factors assure practical identity; surely, they
then also assure that any difference cannot be of consequence. Indeed,
nonmateriality is the full purpose of the [***32] Memorandum's criteria. The
"proof of the pudding" is in the fact of its complete accounting acceptability
to the FHLBB. Indeed, as has been noted, it is difficult to reconcile
substantial identity for financial accounting purposes with a material
difference for tax accounting purposes. See First Federal Savings & Loan Assn.
of Temple v. United States, 694 F. Supp. 230, 245 (WD Tex. 1988), aff'd, 887 F.
2d 593 (CA5 1989), cert. pending No. 89-1927. Common sense so dictates.
This should suffice and be the end of the analysis. Other facts, however,
solidify the conclusion: The retention by the transferor of 10% interests,
enabling it to keep on servicing its loans; the transferor's continuing to
collect the payments due from the borrowers so that, so far as the latter were
concerned, it was business as usual, exactly as it had been; the obvious lack of
concern or dependence of the transferor with the "differences" upon which the
Court relies (as transferees, the taxpayers made no credit checks and no
appraisals of collateral, see 890 F. 2d 848, 849 (CA6 1989)); 90 T. C. 372, 382
(1988); [***33] 682 F. Supp. 1389, 1392 (ND Tex. 1988); the selection of the
loans by a computer programmed to match mortgages in accordance with the
Memorandum R-49 criteria; the absence of even the names of the borrowers in the
closing schedules attached to the agreements; Centennial's receipt of loan files
only six years after its exchange, id., at 1392, n. 5; the restriction of the
interests exchanged to the same State; the identity of the respective face and
fair market values; and the application by the parties of common discount
factors to each side of the transaction -- all reveal that any differences that
might exist made no difference whatsoever and were not material. This
demonstrates the real nature of the transactions, including nonmateriality of
the claimed differences.
[*572] We should be dealing here with realities and not with superficial
distinctions. As has been said many times, and as noted above, in income tax
law we are to be concerned with substance and not with mere form. When we stray
from that principle, the new precedent is likely to be a precarious beacon for
the future.
I respectfully dissent on this issue.
John F. TUFTS and Mary A. Tufts, et al.,
Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
No. 79-2258
UNITED STATES COURT OF APPEALS, FIFTH CIRCUIT. UNIT A
651 F.2d 1058; 1981 U.S. App. LEXIS 11054; 81-2 U.S. Tax
Cas. (CCH) P9574; 48 A.F.T.R.2d (RIA) 5660
JUDGES: Before BROWN, THORNBERRY and WILLIAMS, Circuit Judges.
OPINIONBY: THORNBERRY
OPINION: [**3]
[*1059]
In August 1970, John Tufts and the remaining appellants formed a general
partnership for the purpose of constructing an apartment complex in Duncanville,
Texas. The partnership arranged for a loan of approximately.$ 1.8 million in
order to finance construction of the complex. The mortgage note covered the
entire cost and provided that neither the partnership nor the partners were
personally liable for its repayment. The complex was completed in August 1971.
Due to adverse economic conditions in the Duncanville area, the income generated
by the complex was never enough to enable the partnership to make payments on
the mortgage principal. As of August 28, 1972, the fair market value of the
property had declined to.$ 1.4 million, and the principal balance due on the
mortgage note remained at.$ 1.8 million. On that date, each partner sold his
partnership interest and all of his right, title, and interest in property owned
by the partnership to Fred Bayles, an unrelated third party. n1 Mr. Bayles
agreed to pay the expenses incurred by the partners as a result of the sale, up
to $ 250. He paid no other consideration, and acquired the complex subject to
the nonrecourse [**4] liability.
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n1. I.R.C. @ 741 provides that gain or loss from the sale or exchange of an
interest in a partnership shall be considered as gain or loss from the sale or
exchange of a capital asset, except as otherwise provided in I.R.C. @ 751
(relating to unrealized receivables and inventory items which have appreciated
substantially in value.
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Each partner had included his proportionate share of the entire.$ 1.8 million
in computing his basis in the partnership, and the Commissioner did not dispute
the propriety of that computation. The Commissioner, however, included the full
amount of the partnership nonrecourse liability in the amount realized upon the
sale and therefore determined that each of the partners had realized a gain on
the sale of his partnership interest. n2 The partners appealed to the tax court,
arguing that nonrecourse liabilities should be included in amount realized only
to the extent of the fair market value of the partnership property securing the
indebtedness. The tax court upheld [**5] the Commissioner, and the taxpayers
filed this appeal.
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n2. I.R.C. @ 1001 provides in part:
(a) COMPUTATION OF GAIN OR LOSS. The gain from the sale or other disposition
of property shall be the excess of the amount realized therefrom over the
adjusted basis provided in section 1011 for determining gain, and the loss shall
be the excess of the adjusted basis provided in such section for determining
loss over the amount realized.
(b) AMOUNT REALIZED. The amount realized from the sale or other disposition
of property shall be the sum of any money received plus the fair market value of
the property (other than money) received.
(emphasis added).
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The Supreme Court held in Crane v. Commissioner, 331 U.S. 1, 67 S. Ct. 1047,
91 L. Ed. 1301 (1947), that when property subject to a mortgage on which the
owner of the property assumes no personal liability is sold, the amount realized
includes the amount of the unassumed mortgage. n3 In footnote 37 [*1060] of
the Crane opinion, however, the Court observed:
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n3. Mrs. Crane inherited an apartment building worth $ 250,000, subject to a
nonrecourse mortgage in the same amount, held it for seven years, and sold it,
subject to the unamortized mortgage, for $ 2500 in cash. She reported a gain of
$ 2500 on the sale, arguing that the property she had acquired from her
husband's estate was only the equity in the building (which under I.R.C. @
1014 entitled her to a basis of zero), and that the amount realized for the
equity when she sold it was $ 2500. The Supreme Court rejected her argument,
holding that the property inherited by Mrs. Crane was not merely the equity, but
the real estate (which under @ 1014 had an unadjusted basis of $ 250,000), and
that the amount realized on the sale also included the full amount of the
nonrecourse debt.
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
[**6]
Obviously, if the value of the property is less than the amount of the
mortgage, a mortgagor who is not personally liable cannot realize a benefit
equal to the mortgage. Consequently, a different problem might be encountered
where a mortgagor abandoned the property or transferred it subject to the
mortgage without receiving boot. That is not this case.
331 U.S. at 14 n.37, 67 S. Ct. at 1054. The question presented by this appeal is
whether footnote 37 creates an exception to the Crane holding through its clear
implication that the amount realized on the disposition of property encumbered
by a nonrecourse mortgage cannot exceed the fair market value of the property.
Our analysis of the reasons underlying the Crane decision leads us to the
conclusion that such a fair market value limitation is warranted. We therefore
reverse the judgment of the tax court.
The Commissioner relies primarily on the decision in Millar v. Commissioner,
577 F.2d 212 (3rd Cir.), cert. denied, 439 U.S. 1046, 99 S. Ct. 721, 58 L. Ed.
2d 704 (1978). The Millar court rejected a literal reading of footnote 37 in
view of what it thought to be the principal reason underlying the Crane
decision. The court [**7] focused on the following language:
The crux of this case, really, is whether the law permits her to exclude
allowable deductions from consideration in computing gain. We have already
showed that, if it does, the taxpayer can enjoy a double deduction, in effect,
on the same loss of assets.
557 F.2d at 215, quoting Crane, 331 U.S. at 15-16, 67 S. Ct. at 1055. According
to the Millar panel, the Supreme Court was primarily concerned that the taxpayer
might enjoy some sort of double deduction. The tax court below, as well as the
Commissioner on appeal, agreeing with Millar, also identified this concern for
double deductions as the principal reason for the Crane holding. They invoke the
Crane double deduction language in support of a tax benefit theory: the
argument, in essence, is that a taxpayer who has previously enjoyed the benefit
of large tax deductions, without placing his own assets at risk, has, by taking
those deductions, improved his economic position, thus realizing gain. According
to the Commissioner and the tax court, the taxpayer, on disposing of the
property, must somehow be made to account for the benefits previously enjoyed.
We do not agree that this concern [**8] for double deductions was the
principal reason underlying the Crane decision. The Crane language leaves no
doubt that the Court thought that Mrs. Crane had improved her financial
condition by availing herself of the allowable deductions. But before the Court
had even mentioned double deductions, it had already concluded that the
Commissioner had properly determined the amount realized. After reaching that
conclusion, the Court acknowledged the distinction between statutory income
(that which Congress has decided to reach through legislation) and
constitutional income (that which Congress has the power to reach, if it chooses
to do so). Mrs. Crane had argued in the alternative that she had been taxed on
what was not income within the meaning of the sixteenth amendment. The Court
responded to this constitutional argument in the last paragraph of its opinion,
and in that last paragraph the Court for the first time expressed concern for
double deductions. We therefore prefer to read this expression of concern as
primarily a response to Mrs. Crane's constitutional argument, and not as the
principal justification for the statutory holding that the Court had announced
earlier in the opinion. [**9] n4
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n4. We must confess that our preference stems in part from our uncertainty as
to the exact nature of the "double deductions" that concerned the Court. The
Court apparently was endorsing the reasoning of Judge Learned Hand, the author
of the opinion in the Court of Appeals, who stated:
By hypothesis (the taxpayer) will have been allowed deductions seriatim,
based upon the actual value of the buildings; and he will in addition have got a
reduction in his gain to the extent to which actual "wear and tear" has reduced
the selling price. Manifest justice demands that he must surrender one or the
other....
Commissioner v. Crane, 153 F.2d 504, 505 (2nd Cir. 1945). We had always
supposed that Congress chose to allow depreciation deductions on the assumption
that wear and tear would diminish the value of the property. In other words,
Congress decided to compensate a property owner, by allowing him to take
depreciation deductions, for an expected loss in value due to deterioration of
the property. We therefore do not understand why, if the property does in fact
decline in value as was expected, "manifest justice" requires the taxpayer to
somehow "surrender" the previous deductions or the gain that he never realized.
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[**10]
There is an even more compelling reason why the fact that a taxpayer has
previously [*1061] enjoyed the benefit of large depreciation deductions is
insufficient to justify an expansion of the definition of amount realized. We
see, by looking to the Internal Revenue Code, that Congress has already in fact
accounted for those previous deductions. According to the Code, "gain" from the
sale or other disposition of property is computed by subtracting the "adjusted
basis" from the "amount realized." I.R.C. @ 1001(a). The "adjusted basis" is the
cost of the property adjusted to reflect the depreciation, depletion, and other
costs chargeable against the property. I.R.C. @ 1016. Thus, any tax benefits
that the taxpayer may have received in the form of prior deductions have already
been factored into the gain equation through adjustments to basis. Since those
deductions have been accounted for through adjustments to basis, it follows
logically that they cannot also support an expansion of the definition of amount
realized. To account for those deductions twice in the same equation by
expanding the definition of amount realized as well as adjusting basis downward
would, we think, be [**11] taxing the taxpayer twice on the same component of
gain. n5 The Commissioner's reliance on a theory of tax benefit, then, is
misplaced. The Code clearly provides for a "recapture" of the prior
deductions, n6 but not through its definition of amount realized.
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n5. We note that our analysis is entirely consistent with the Crane language.
We fully agree that the law does not permit a taxpayer "to exclude allowable
deductions from consideration in computing gain." 331 U.S. at 15-16; 67 S. Ct.
at 1055. We have merely concluded that Congress chose to "consider" and account
for those allowable deductions through adjustments to basis, and not though an
expansive definition of amount realized.
n6. In fact, the Code does even more than merely recapture prior depreciation
deductions actually taken by the taxpayer. Section 1016 requires that the basis
of property be reduced by the amount of depreciation allowable whether or not it
is taken. Virginian Hotel Corp. v. Helvering, 319 U.S. 523, 63 S. Ct. 1260, 87
L. Ed. 1561 (1943). Section 1016 thus operates whether or not the taxpayer has
enjoyed a tax benefit via a deduction. In contrast, the tax benefit rule is
designed only to prevent the taxpayer from making actual personal gains through
unwarranted deductions. See, e. g., I.R.C. @ 111 (bad debts, prior taxes, or
delinquency amounts written off in prior years must be included in income when
recovered, unless the prior deduction did not reduce the tax).
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[**12]
When we look to what the Court said immediately before it announced its
conclusion that the Commissioner had properly determined the amount realized, we
see that the Court justified its result on a theory of economic benefit, first
recognizing that the term "amount realized" could be expanded where an economic
benefit equivalent to cash could be identified. The Court began by noting that
if Mrs. Crane had been personally liable on the mortgage and the purchaser had
either paid or assumed it, the amount so paid or assumed would clearly have been
considered a part of the amount realized because Mrs. Crane would have received
the benefit of the payment "in "as real and substantial (a sense)' " as if the
money had been paid to her and then paid over by her to her creditors. 331 U.S.
at 13, 67 S. Ct. at 1054, citing United States v. Hendler, 303 U.S. 564, 58 S.
Ct. 655, 82 L. Ed. 1018 (1938). That proposition and the economic principle from
which it derives are indisputable: when a debt on which a taxpayer is personally
liable is discharged, the taxpayer is freed from the necessity of paying the
obligation with cash or other assets equal in value to the principal amount of
the debt. United [**13] States v. Kirby Lumber Co., 284 U.S. 1, 52 S. Ct. 4,
76 L. Ed. 131 (1931). What the Court thought followed from that proposition,
however, is worth quoting:
[*1062] (W)e think that a mortgagor, not personally liable on the debt,
who sells the property subject to the mortgage and for additional consideration,
realizes a benefit in the amount of the mortgage as well as the boot.[37 If a
purchaser pays boot, it is immaterial as to our problem whether the mortgagor is
also to receive money from the purchaser to discharge the mortgage prior to
sale, or whether he is merely to transfer subject to the mortgage it may make a
difference to the purchaser and the mortgagee, but not to the mortgagor. Or put
in another way, we are no more concerned with whether the mortgagor is, strictly
speaking, a debtor on the mortgage, than we are with whether the benefit to him
is, strictly speaking, a receipt of money or property. We are rather concerned
with the reality that an owner of property, mortgaged at a figure less than that
at which the property will sell, must and will treat the conditions of the
mortgage exactly as if they were his personal obligations. 38 If he transfers
subject to [**14] the mortgage, the benefit to him is as real and substantial
as if the mortgage were discharged, or as if a personal debt in an equal amount
had been assumed by another.
331 U.S. at 14, 67 S. Ct. at 1054-55 (emphasis added).
This economic benefit theory is, we think, seriously flawed, in that it is
premised on the notion that "an owner of property, mortgaged at a figure less
than that at which the property will sell, must and will treat the conditions of
the mortgage exactly as if they were his personal obligations." We admit that we
initially succumbed to the facile appeal of that notion, but on reflection we
are convinced that it rings true only so long as the taxpayer actually wants to
keep the property. n7 If the taxpayer decides, for any reason whatsoever, that
he no longer wants the burdens and responsibilities that accompany ownership, he
can transfer the property to a third party with absolutely no regard to that
party's willingness or ability to meet the mortgage obligations, yet rest
assured that his other assets cannot be reached. We agree with Professor
Bittker:
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n7. Professor Bittker provides an analogy:
The Court was, of course, right in asserting that the owner of mortgaged
property must keep up the payments if he wants to retain the property and that
for this period of time, he must treat the debt as a personal obligation whether
he is personally liable or not. It does not follow, however, that the benefit to
him from transferring the property subject to the mortgage is the same in both
cases. If you crave gourmet meals, you must pay for them so long as your
addiction continues; but once you break the habit, you need pay only for those
you bought on credit in the past, not for those that you will skip in the
future. So it is with mortgages. Nonrecourse obligations can be disregarded as
soon as the property is sold, given away, or abandoned; personal liability
persists even after the property has been disposed of, whether the new owner
assumes or takes subject to the debt.
Thus, Crane overstates the resemblance between nonrecourse and personal
obligations.
Bittker, Tax Shelters, Nonrecourse Debt, and the Crane Case, 33 Tax L.Rev.
277, 281 (1978). Professor Bittker rejects the economic benefit theory as
"wholly fallacious," but justifies the result reached by the Court on what he
calls a balancing entry theory. The Crane decision, according to Bittker, "was
justifiable because it brought the tax consequences of the taxpayer's dealings
with her property into harmony with economic reality by recapturing her
depreciation deductions to the extent that they exceeded her investment in the
encumbered property." Id. at 282. Professor Bittker, then, agrees with the
Commissioner that it is somehow unfair for a taxpayer to enjoy the benefit of
substantial deductions without having placed his own assets at risk. As we will
note, we think that argument is properly directed at the Congress, not at the
courts. It may be that Professor Bittker was so directing it. See id. at 284.
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[**15]
Relief from a nonrecourse debt is not an economic benefit if it can be
obtained only by giving up the mortgaged property. It is analogous to the relief
one obtains from local real property taxes by disposing of the property. Like
nonrecourse debt, the taxes must be paid to retain the property; but no one
would suggest that the disposition of unprofitable property produces an economic
benefit equal to the present value of the taxes that will not be paid in the
future.
Bittker, Tax Shelters, Nonrecourse Debt, and the Crane Case, 33 Tax L.Rev. 277,
282 [*1063] (1978). We do not deny that Mrs. Crane received some benefit: a
purchaser had to pay off the mortgage or at least be willing to take the
property subject to the mortgage before Mrs. Crane could pocket her $ 2500 in
equity. We do, however, seriously question whether the full amount of
nonrecourse debt is an accurate measure of that benefit.
Because, as indicated above, we have serious reservations about the Crane
decision, we decline to extend it beyond the facts of that case, and we
therefore conclude that the fair market value limitation so "obviously"
anticipated by footnote 37 is warranted. We hold that the [**16] fair market
value of the property securing a nonrecourse debt limits the extent to which the
debt can be included in the amount realized on disposition of the property. n8
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n8. The appellants argued in the alternative that I.R.C. @ 752(c) expressly
limits the amount realized from the transfer of their partnership interests to
the fair market value of the property securing the nonrecourse debt. Section 752
provides in full as follows:
@ 752. Treatment of certain liabilities
(a) Increase in partner's liabilities. Any increase in a partner's share of
the liabilities of a partnership, or any increase in a partner's individual
liabilities by reason of the assumption by such partner of partnership
liabilities, shall be considered as a contribution of money by such partner to
the partnership.
(b) Decrease in partner's liabilities. Any decrease in a partner's share of
the liabilities of a partnership, or any decrease in a partner's individual
liabilities by reason of the assumption by the partnership of such individual
liabilities, shall be considered as a distribution of money to the partner by
the partnership.
(c) Liability to which property is subject. For purposes of this section, a
liability to which property is subject shall, to the extent of the fair market
value of such property, be considered as a liability of the owner of the
property.
(d) Sale or exchange of an interest. In the case of a sale or exchange of an
interest in a partnership, liabilities shall be treated in the same manner as
liabilities in connection with the sale or exchange of property not associated
with partnerships.
Notwithstanding the unambiguous language of @ 752(c), the Commissioner
contended that Congress intended the fair market value limitation of that
subsection to apply only when encumbered property was contributed to or
distributed from a partnership, and that @ 752(d) somehow operates independently
of @ 752(c). Because @ 752(c) provides for a fair market value limitation, it
necessarily conflicts, according to the Commissioner, with @ 752(d), which
provides that liabilities associated with the sale or exchange of partnership
interests are to be treated in the same manner as liabilities associated with
the sale or exchange of other property. Obviously, our holding extinguishes any
conflict that the Commissioner might see in the provisions of @ 752. Further,
since @ 752(c) is generally regarded to be an intended codification of the Crane
doctrine, see, e.g., Perry Limited Partnerships and Tax Shelters: The Crane Rule
Goes Public, 27 Tax L.Rev. 525, 542 (1972), it seems that our holding is
consistent with congressional understanding of the Crane case.
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[**17]
REVERSED. n9
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n9. Because our holding is in direct conflict with decisions in other
circuits, we think the following remarks are necessary to put this case in its
proper perspective. First, and most important, the precise issue before this
court is extremely narrow: whether the tax court properly included the full
amount of nonrecourse debt in amount realized. Congress specifically defined
amount realized to be the sum of any money received plus the fair market value
of the property (other than money) received. I.R.C. @ 1001(b). The Supreme Court
has held that the definition can be expanded where an economic benefit
equivalent to cash can be identified. Significantly, whether the taxpayers
properly included the full amount of the nonrecourse debt in the bases of their
partnership interests is not an issue in this case.
We detect in the case law and the literature a legitimate concern for
potential abuses or at least misuses of the tax law through various tax shelter
schemes. Judge Friendly recently stated:
If non-recourse mortgages contribute to the basis of property, then they must
be included in the amount realized on its sale. Any other course would render
the concept of basis nonsensical by permitting sellers of mortgaged property to
register large tax losses stemming from an inflated basis and a diminished
realization of gain. It would also permit depreciation deductions in excess of a
property holder's real investment which could never subsequently be recaptured.
Estate of Levine v. Commissioner, 634 F.2d 12 (2nd Cir. 1980). See also
Bittker, supra note 7, at 284-84. Judge Friendly has identified, we think, the
two primary concerns that could prompt a decision like Millar. The first is that
taxpayers will be able to use nonrecourse financing to inflate their bases in
order to enjoy the benefit of large tax deductions that bear no relationship to
actual economic loss. The second appears to be nothing more than a concern for
fairness. The argument, we suppose, is that it is somehow unfair for a taxpayer
to enjoy the benefit of substantial deductions without having invested his own
funds or placed his own assets at risk.
We agree that there exists a potential for abuse. But Judge Friendly also
correctly identified the reason that potential exists: "non-recourse mortgages
contribute to the basis of property." The real crux of the problem, then, is the
taxpayer's ability to manipulate his basis and adjusted basis through the use of
nonrecourse financing. The solution, in our opinion, is to deal directly with
the definitions of "basis" and "adjusted basis," either judicially or through
legislation. See, e.g., Gibson Products Co. v. United States, 460 F. Supp. 1109
(N.D.Tex.1978) (nonrecourse indebtedness in excess of fair market value of the
property securing the debt cannot be included in basis), affirmed, 637 F.2d 1041
(5th Cir. 1981); Estate of Franklin v. Commissioner, 544 F.2d 1045 (9th Cir.
1976). It is not a solution to distort the definition of amount realized by
finding an economic benefit equivalent to cash where none exists. There is
simply no relationship between basis, adjustments to basis, and amount realized,
except where Congress has specifically legislated for recapture. In response to
the notion that it is unfair for a taxpayer to enjoy the benefit of substantial
deductions on property acquired with nonrecourse funds, we need only state that
Congress knows how to limit deductions to amounts that the taxpayer actually
places at risk, see, e.g., I.R.C. @ 465, and has not yet done so under the
circumstances of this case.
Finally, we must respond to Judge Williams' thoughtful concurring opinion. We
do not think that the fair market value limitation in I.R.C. @ 1001(b) applies
to this case. Judge Williams characterizes the release of nonrecourse
indebtedness as "property (other than money) received" within the meaning of
that section. Crane expanded the definition of amount realized to include
economic benefits equivalent to cash. In our view, intangible cash equivalents
are more akin to "money" than to "property." But even if Judge Williams is
correct in this regard, we are troubled by his application of the
freeing-of-assets theory. That theory makes perfect sense in the case of
recourse indebtedness: when recourse indebtedness is assumed or extinguished,
other assets are "freed" in the sense that the seller no longer faces the
prospect of losing them to his creditor. In contrast, it seems that property
subject to nonrecourse indebtedness is in no sense "freed" but is actually
"lost" when transferred subject to or relinquished in satisfaction of the debt.
Further, we do not agree with Judge Williams' conclusion that the fair market
value of the release "corresponds directly" with the fair market value of the
property securing the nonrecourse indebtedness. As we noted in the text, Mrs.
Crane benefited in that a release was a prerequisite to recovery of her $ 2500
equity. The fair market value of the release is a measure of that benefit. But
because we remain unpersuaded that Mrs. Crane, in recovering her equity,
"benefited" to the extent of $ 255,000, we think the fair market value of the
release must be something substantially less.
We do agree with Judge Williams that whether we need only give great weight
to the Commissioner's position or whether we may reject it only if it is
unreasonable makes no difference. Because of our reservations about the logical
underpinnings of Crane, we think that an extension of it would be unreasonable.
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[**18]
CONCUR: JERRE S. WILLIAMS, Circuit Judge, concurring:
I concur with the result reached by our panel because the Commissioner's
position is [*1064] inconsistent with the plain language of I.R.C. @ 1001(b)
and I.R.C. @ 752(c). I part company with the majority opinion because it rests
on a difference of opinion with the Service over the construction of @ 1001 in
light of the Crane doctrine. I doubt that we have authority to strike down the
Commissioner's interpretation on the basis of "serious reservations about the
Crane decision." We are authorized, however, to invalidate administrative
regulations that conflict with the statute on which they purport to be based.
I understand the majority's reluctance to extend the Supreme Court's approach
to the taxation of nonrecourse debt cancellation taken in Crane v. Commissioner.
Nevertheless, Crane is the law. In this case, we review the Commissioner's
effort to extend the Crane doctrine to plug a breach in the dike holding back a
potential flood of tax shelter schemes employing exaggerated depreciation and
loss deduction claims grounded on nonrecourse financing-inflated basis. The
majority opinion discusses this "potential [**19] for abuse" inherent in our
ruling, n.9 supra, yet concludes that the Commissioner's proposed solution,
reflected in Treas.Reg. @ 1.1001-2(b) (1980), constitutes an unacceptable
"distortion of the definition of amount realized."
With admiration for the logical rigor exhibited in the majority's analysis of
this [*1065] problem, I think it is essential to take heed of the
constraints our Court operates under when we review an aspect of the intricate
enforcement mechanism devised by the Internal Revenue Service to administer the
tax laws. If we ignore the adoption of Treas.Reg. @ 1.1001-2(b) during the
pendency of this appeal n1 and the position asserted by the Internal Revenue
Service as merely an administrative interpretation, our Court is obliged to give
great weight to the Commissioner's position. Compare United States v. Fisher,
353 F.2d 396 (5th Cir. 1965) (appellate court is obliged to give "great weight"
to Treasury Department's administrative construction of the National Firearms
Act). If, on the other hand, we recognize that the Commissioner's interpretation
before us on this appeal has now been elevated to the status of a regulation, we
may invalidate it "only if it [**20] is unreasonable and inconsistent with
the statute." Delta Metalforming Co., Inc. v. Commissioner of Internal Revenue,
632 F.2d 442, 449 (5th Cir. 1980) (per Judge Brown). In matters of tax code
construction and administration, we must bear in mind that "(t)he choice among
reasonable interpretations is for the Commissioner, not the Courts. National
Muffler Dealers Ass'n, Inc. v. United States, 440 U.S. 472, 488, 99 S. Ct. 1304,
1312, 59 L. Ed. 2d 519 (1979). Whether we regard the view advanced by the
Commissioner on this appeal as a mere interpretation or a regulation makes no
difference. In this case, the plain language of the statute conflicts with the
Service's position.
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n1. Treas.Reg. @ 1001-2(b) was promulgated on December 11, 1980.
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Reliance on the literal language of the tax code is a precarious position,
especially when dealing with Crane-like situations. n2 Nevertheless, it seems
apparent to me that the question left dangling by footnote 37 of Crane is
squarely answered by I.R.C. @ 1001(b), which [**21] defines "amount realized"
as "the sum of any money received plus the fair market value of the property
(other than money) received" (emphasis added). Although the Supreme Court
expressly avoided characterizing the taxable economic benefit a transferor of
property receives when his transferee takes subject to a nonrecourse mortgage as
either money or property, 331 U.S. at 14, 67 S. Ct. at 1054, Judge Learned Hand
in the same case in lower court declared "it is the law...that...the release (of
nonrecourse indebtedness) would have been "property (other than money) received'
within the meaning of @ 111(b) (now I.R.C. @ 1101(b))." Commissioner v. Crane,
153 F.2d 504, 505 (2d Cir. 1945). Combining the freeing-of-assets theory
underlying the cancellation of indebtedness cases, see United States v. Kirby
Lumber Co., 284 U.S. 1, 52 S. Ct. 4, 76 L. Ed. 131 (1931), with the Crane
principle that recourse and nonrecourse indebtedness be treated alike under @
1001, the fair market value of the release corresponds directly to the fair
market value of the property securing the nonrecourse indebtedness. n3
Therefore, @ 1001(b) imposes tax liability for receipt of a release of
nonrecourse indebtedness, [**22] but only to the extent of the fair market
value of the property transferred subject to the nonrecourse mortgage.
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n2. One commentator on the Crane doctrine offered this admonition on tax code
construction: "Everyday meanings are only of secondary importance when
construing the words of tax statute and are very seldom given any weight when a
more abstruse and technical meaning is available." Adams, Exploring the Outer
Boundaries of the Crane Doctrine; an Imaginary Supreme Court Opinion, 21 Tax
L.Rev. 159, 164 (1966).
n3. This reckoning echoes the Supreme Court's language, to which Footnote 37
was appended, in Crane: "we think that a mortgagor, not personally liable on the
debt, who sells the property subject to the mortgage and for additional
consideration, realizes a benefit in the amount of the mortgage as well as the
boot." 331 U.S. at 14, 67 S. Ct. at 1054 (footnote omitted) (emphasis added).
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The result compelled by the fair market value limitation of @ 1001(b) is also
compelled in this case involving [**23] partnership taxation by I.R.C. @
752(c), which inserts a parallel fair market value limitation on transfers of
mortgaged property within and [*1066] by a partnership. Again, the Service's
view that @ 752(c) operates independently of @ 752(d), see n.8, supra, is at war
with the plain language of the statute. Subsection (c) applies: "(f)or purposes
of this section." Subsection (d) is part of @ 752 "this section." Even if one
were to adopt the Millar view and ignore the fair market value limitation of @
1001(b), the clear and specific imposition of a fair market value limitation in
@ 752(c) would control over @ 752(d)"s general reference to the computation
embracing the @ 1001 definition in the partnership taxation context. Our
reading of @ 1001(b) is further justified because it does not permit the
development of a disparity in the taxation of partnerships as opposed to other
business entities.
The result @ 1001(b) and @ 752(c) compel me to reach produces grave
consequences for the equitable administration of the tax code. We abandon the
certainty and predictability of calculations based on amounts specified in the
nonrecourse mortgage instrument in favor of the elusive [**24] concept of
fair market value. Under our decision, borrowers with personal liability receive
less favorable treatment than nonrecourse borrowers on mortgaged property that
declines in value. While I.R.C. @ 465's "at risk" limitations on loss deduction
from investments in certain speculative ventures may curb the potential for tax
shelter abuses employing nonrecourse financing, @ 465 does not reach real estate
investments of the sort transferred by the Tufts partnership. Our holding means
that the Internal Revenue Service or Congress will have to retool the code
mechanism for policing exaggerated depreciation and loss deduction claims
grounded on a basis inflated by nonrecourse borrowing. Section 1001 and 752
simply do not authorize the administrative solution the Service seeks to defend
here.
Crane is correct and does not warrant a restrictive interpretation. But the
Commissioner's extension of Crane on review here collides directly with
controlling statutory language when the fair market value of the property is
less than the amount of the adjusted base, i.e. the amount of the nonrecourse
debt less the deductions taken.
James E. Threlkeld, Petitioner-Appellee, v. Commissioner of
Internal Revenue, Respondent-Appellant
Nos. 87-1511, 87-1592
UNITED STATES COURT OF APPEALS FOR THE SIXTH CIRCUIT
848 F.2d 81; 1988 U.S. App. LEXIS 7252; 88-1 U.S. Tax Cas.
(CCH) P9370; 61 A.F.T.R.2d (RIA) 1285
JUDGES: Merritt and Kennedy, Circuit Judges; and Contie, Senior Circuit Judge.
OPINION: [*81] CONTIE, Senior Circuit Judge.
The Commissioner of Internal Revenue (Commissioner) appeals from the February
25, 1987 and March 20, 1987 decisions of the United States Tax Court. For the
following reasons, we affirm the Tax Court's judgments.
I.
On May 10, 1979, taxpayer James Threlkeld filed a diversity action against J.
B. Williams in the United States District Court for the Western District of
Tennessee, alleging malicious prosecution. Williams had contracted to purchase
some real estate [**2] from taxpayer and another, and then initiated and
subsequently lost chancery court proceedings in an attempt to rescind the
contract.
In his complaint, Threlkeld alleged that Williams "instituted, continued, and
prosecuted his claims" in the chancery suit "without probable cause and with
malice." Taxpayer also alleged that Williams' actions in bringing the chancery
court suit caused various injuries described as follows:
Plaintiff was subjected to indignity, humiliation, inconvenience, and pain and
distress of mind, was prevented from attending to his usual professional
pursuits, incurred expenses and costs in defending defendant's claims in and
pertaining to the chancery suit, suffered injury to his professional reputation,
and suffered injury to his credit reputation.
Additionally, taxpayer filed two other suits against Williams and others which
alleged that certain fraudulent conveyances of property were made in an effort
to insulate those properties from taxpayer's original chancery court judgment.
[*82] On December 8, 1980, Threlkeld settled his malicious prosecution
suit. Taxpayer agreed to release all other pending claims and to assign the
original chancery court judgment. In [**3] consideration of settlement of
his claims, taxpayer received $ 300,000 allocated as follows:
$ 75,000
For the release of taxpayer's claims against J. B. Williams asserted in the
malicious prosecution action for damage to his professional reputation.
$ 75,000
For the release of taxpayer's claims against J. B. Williams asserted in the
malicious prosecution action for damage to his credit reputation.
$ 74,980
For the release of taxpayer's claims against J. B. Williams asserted in the
malicious prosecution action for indignity, humiliation, inconvenience, and pain
and distress of mind.
$ 20
For the release of taxpayer's claims against J. B. Williams and others asserted
in the fraudulent conveyance actions.
$ 75,000
For the assignment of the judgment by taxpayer.
Threlkeld received $ 86,000 of the total settlement in 1980 and $ 214,000 in
1981. $ 21,500 of the amount received in 1980 and $ 53,500 of the amount
received in 1981 represented settlement for damages to taxpayer's professional
reputation.
Threlkeld excluded most of the settlement from gross income on his 1980 tax
return. The Commissioner assessed a deficiency, and taxpayer petitioned the
[**4] Tax Court seeking a redetermination of the deficiency. The Commissioner
subsequently conceded that all of the amount at issue except the $ 21,500
attributable to damages for injury to taxpayer's professional reputation was
excludable under I.R.C. @ 104(a)(2) which excludes from gross income "the amount
of any damages received (whether by suit or agreement and whether as lump sums
or as periodic payments) on account of personal injuries or sickness."
Therefore, the only issue before the Tax Court was whether the $ 21,500
attributable to damages for injury to taxpayer's professional reputation was
likewise excludable.
Threlkeld followed the same procedure when filing his 1981 tax return. Again,
the Commissioner assessed a deficiency, and taxpayer petitioned the Tax Court
seeking a redetermination of the deficiency. The parties agreed to be bound by
the Tax Court's decision regarding taxpayer's 1980 tax return.
On December 8, 1986, the Tax Court with one judge dissenting filed an opinion
which held that there is no valid distinction between damages received for
injury to personal reputation and those received for injury to professional or
business reputation for the purposes of section [**5] 104(a)(2). The Tax
Court further held that damages received in settlement of a claim for malicious
prosecution of a civil proceeding under Tennessee law are damages received on
account of personal injuries.
Thereafter, on February 25, 1987, the Tax Court filed a decision which stated
that pursuant to its opinion filed on December 8, 1986, there was a deficiency
in income tax due from taxpayer for the 1980 taxable year in the amount of $
2,032.39. n1 Subsequently, on March 20, 1987, the Tax Court filed a decision
which stated that pursuant to its opinion filed on December 8, 1986, there was
no deficiency in income tax due from taxpayer for the 1981 taxable year.
- - - - - - - - - - - - - - - - - -Footnotes- - - - - - - - - - - - - - - - - -
n1 It is unclear how the Tax Court arrived at this deficiency since the Tax
Court opinion is in favor of the taxpayer.
- - - - - - - - - - - - - - - - -End Footnotes- - - - - - - - - - - - - - - - -
The Commissioner filed timely appeals from each of these decisions, and the
cases were consolidated by this court. We must decide whether the Tax Court
erred in holding that that portion of a settlement which was allocated to injury
to taxpayer's professional reputation constitutes damages received on account of
personal injuries, and is, therefore, excludable from gross income under section
104(a)(2).
[*83] [**6] II.
This case involves an appeal from decisions of the United States Tax Court.
The United States Courts of Appeals have exclusive jurisdiction to review the
decisions of the Tax Court, except as provided in 28 U.S.C. @ 1254, in the same
manner and to the same extent as decisions of the district courts in civil
actions tried without a jury. I.R.C. @ 7482(a). Whether the Tax Court properly
refused to draw a distinction between personal reputation and professional
reputation for the purposes of I.R.C. @ 104(a)(2) is a question of law subject
to de novo review. Roemer v. Commissioner, 716 F.2d 693, 696 (9th Cir. 1983).
The Internal Revenue Code of 1954 is applicable to the instant case. Section
61(a) states that except as otherwise provided, gross income means all income
from whatever source derived. I.R.C. @ 61. Section 104(a)(2) provides an
exception from gross income for "the amount of any damages received (whether by
suit or agreement and whether as lump sums or as periodic payments) on account
of personal injuries or sickness." The regulations specify that "the term
'damages received (whether by suit or agreement)' means an amount received
(other than workmen's compensation) [**7] through prosecution of a legal
suit or action based upon a tort or tort type rights, or through a settlement
agreement entered into in lieu of such prosecution." 26 C.F.R. @ 1.104-1(c).
In reaching its holding that there is no valid distinction between damages
received for injury to personal reputation and those received for injury to
professional or business reputation for purposes of section 104(a)(2), the Tax
Court relied primarily on the Ninth Circuit's opinion in Roemer. In Roemer, the
dispositive issue on appeal was whether the defamation of an individual
constituted a personal injury for the purposes of section 104(a)(2). Roemer, 716
F.2d at 694. Since the defamation of an individual is a personal injury under
California law, the compensatory damages received by Roemer in his defamation
suit were excludable from gross income under section 104(a)(2) as would be the
compensatory damages received on account of any personal injury. Id. at 700. The
Ninth Circuit allowed the exclusion even though in his complaint for libel
Roemer had alleged "that the defendant's defamatory publication was done 'with
intent to damage his reputation, and to injure him in his business profession
[**8] and occupation.'" Id. at 695. In reaching this conclusion, the court
noted that the nonpersonal consequences of a personal injury, such as a loss of
future income, are often the most persuasive means of proving the extent of the
injury that was suffered, and that the personal nature of an injury should not
be defined by its effect. Id. at 699.
The Third Circuit has recently adopted the reasoning in Roemer in Bent v.
Commissioner, 835 F.2d 67 (3d Cir. 1987). In Bent, a former school teacher had
sued his board of education following his discharge. The question was whether
the amount received by Bent in settlement of his state law claim for damages for
violation of his first amendment right of free speech constituted taxable
income. Id. at 69. Relying on the Ninth Circuit's opinion in Roemer, the Third
Circuit held that the Tax Court did not err in deciding that the whole of the
damages received by the taxpayer was compensation for personal injuries and, as
such, was excludable from gross income. Id. at 70. See also Metzger v.
Commissioner, 845 F.2d 1013 (3d Cir. 1988), aff'g 88 T.C. 834 (1987) (affirming
without opinion a Tax Court decision [**9] which followed the holding in Bent
and extended it to cover the settlement of claims brought pursuant to 42 U.S.C.
@@ 1981, 1982, 1985(3), 1986, 2000e-5, and state discrimination laws).
This court's order in Wolfson v. Commissioner, 651 F.2d 1228 (6th Cir. 1981)
is distinguishable. In Wolfson, we affirmed the Tax Court's determination that
the payment Wolfson received in settlement of a state court action was
includable in gross income because it was intended to compensate him for lost
earnings, and was not a nontaxable form of compensation for personal injury to
his personal reputation. Wolfson had not argued in the Tax Court [*84] that
damages for an injury to professional reputation are excludable from gross
income, and that question was expressly left open by the Tax Court. Accordingly,
we address this question for the first time today.
We note that inRevenue Ruling 85-143 the Commissioner has announced that it
will not follow the Ninth Circuit's decision in Roemer. A Revenue Ruling,
however, is not entitled to the deference accorded a statute or a Treasury
Regulation. Brook, Inc. v. Commissioner, 799 F.2d 833, 836 n.4 (2d Cir. 1986).
Courts may disregard a Revenue [**10] Ruling if it conflicts with the statute
it supposedly interprets or with that statute's legislative history or if it is
otherwise unreasonable. Id. In our opinion,Revenue Ruling 85-143 makes an
unreasonable distinction between injury to personal reputation and injury to
professional reputation. Therefore, we refuse to follow it.
Instead, we adopt the reasoning of the Third and the Ninth Circuits. Since
malicious prosecution is a cause of action which allows recovery for both
personal injuries and injuries to property interests, see 54 C.J.S. Malicious
Prosecution @ 1 (1948), we must look to the nature of the underlying injury to
determine excludability under section 104(a)(2). In the instant case, the
Commissioner has conceded that that portion of the taxpayer's settlement which
constitutes settlement for damage to his personal reputation is excludable from
income under section 104(a)(2). The only issue before this court is whether that
portion of the taxpayer's settlement for damages to his professional reputation
is likewise excludable.
We agree with the Ninth and the Third Circuits that the nonpersonal
consequences of a personal injury, such as a loss of future income [**11] are
often the most persuasive means of proving the extent of the injury that was
suffered, and that the personal nature of an injury should not be defined by its
effect. Injury to a person's hand or arm is a personal injury. This is so even
though it may affect a person's professional pursuits. All income in
compensation of that injury is excludable under section 104(a)(2). Similarly,
the injury to taxpayer's reputation in this case was a personal injury. This is
so even though it affected his professional pursuits. All income in compensation
of that injury is excludable under section 104(a)(2). Accordingly, we AFFIRM the
Tax Court's judgments.
Midland Empire Packing Company, a Corporation, Petitioner,
v. Commissioner of Internal Revenue, Respondent
14 T.C. 635
April 19, 1950, Promulgated
SYLLABUS: Petitioner, a meat-packing corporation, by lining the walls and floor
of its basement with concrete, sought to protect it from the seepage of oil
spilled on the ground by a neighboring refinery. The oil nuisance threatened
continued operation of the packing plant. The purpose of the expenditure for
the concrete liner was not to prepare the plant for operation on a changed or
larger scale, nor to make it suitable for new or additional uses, but only to
permit petitioner to continue the use of the plant, and particularly the
basement, in normal operation. Held, the expenditure for lining the basement
walls and floor was essentially a repair and as such is deductible as an
ordinary and necessary business expense under section 23 (a) of the Internal
Revenue Code.
JUDGES: Arundell, Judge.
OPINIONBY: ARUNDELL
OPINION: This case involves deficiencies in declared value excess
profits tax in the amount of $ 321.34 and excess profits tax in the amount of $
4,092.72 for the taxable year ended November 30, 1943. The issue presented for
decision is whether or not the sum of $ 4,868.81 expended by the petitioner in
oilproofing the basement of its meat-packing plant during the taxable year 1943
is deductible as an ordinary and necessary business expense under section 23 (a)
of the Internal Revenue Code, or, in the alternative, as a loss sustained during
the year and not compensated for by insurance or otherwise under section 23 (f)
of the Internal Revenue Code.
The case has been submitted on a partial stipulation of facts, documentary
evidence, and oral testimony.
FINDINGS OF FACT.
The petitioner, herein sometimes referred to as Midland, is a Montana
corporation and the owner of a meat-packing plant which is located
adjacent to the city of Billings, Yellowstone County, State of Montana. Its
returns for the period here involved were filed with the collector of internal
revenue for the district of Montana. Its books of account and its tax returns
were, during the taxable year and at all other times, kept on the accrual basis
of accounting. Petitioner's returns were based on a fiscal year ending November
30.
The basement rooms of petitioner's plant were used by it in its business for
the curing of hams and bacon and for the storage of meat and hides. These rooms
have been used for such purposes since the plant was constructed in about 1917.
The original walls and floors, which were of concrete, were not sealed against
water. There had been seepage for many years and this condition became worse
around 1943. At certain seasons of the year, when the water in the Yellowstone
River was high, the underground water caused increased seepage in the plant.
Such water did not interfere with petitioner's use of the basement rooms. They
were satisfactory for their purpose until 1943.
The Yale Oil Corporation, sometimes referred to herein as Yale, was the owner
of an oil-refining plant and storage area located some 300 yards
upgrade from petitioner's meat-packing plant. The oil plant was constructed
some years after petitioner had been in business in its present location. Yale
expanded its plant and storage from year to year and oil escaping from the plant
and storage facilities was carried to the ground surrounding the plant of
petitioner. In 1943 petitioner found that oil was seeping into its water wells
and into water which came through the concrete walls of the basement of its
packing plant. The water would soon drain out through the sump, leaving a thick
scum of oil on the basement floor. Such oil gave off a strong odor,
which permeated the air of the entire plant. The oil in the basement and fumes
therefrom created a fire hazard. The Federal meat inspectors advised petitioner
to oilproof the basement and discontinue the use of the water wells or shut down
the plant.
As soon as petitioner discovered that oil had begun to seep into its water
wells and into the basement of its plant, its officers conferred with the
officers of the Yale Oil Corporation and informed Yale that they intended to
hold it liable for all damage caused by the oil which had saturated the
ground around its packing plant. They informed the officials of Yale that they
believed this condition constituted a legal nuisance, which condition they
expected would continue to exist for future years, and that they were
discontinuing the use of their water wells. The officials of Yale were also
informed that the Federal inspectors were requiring petitioner to oilproof the
basement.
A. F. Lamey, attorney at law in Billings, Montana, handled nearly all of the
negotiations for the settlement of the claims made by Midland against the Yale
Oil Corporation for damages resulting from the oil escaping from Yale's
refineries to the premises of the packing company. He represented the Yale
Corporation and the Maryland Casualty Co., which carried liability insurance
with respect to Yale. Early in 1943 he went to the packing plant to inspect the
basement and observed the situation as found above. He talked with Chris
Shaffer, of the petitioner corporation, and informed him that Yale was not
assuming any responsibility and that it was petitioner's duty to take whatever
steps were necessary to minimize damages. Prior to that time, petitioner
suggested piece-meal settlements, which Yale declined to consider
because they felt it would be to their disadvantage to assume responsibility for
any damages without a complete release. Lamey wrote to the Maryland Casualty
Co., Yale's insurer, in a letter dated March 31, 1943, with reference to this
situation, in part as follows:
Past experience indicates that little can be done through a conference with
Mr. Shaffer, who is in charge of the plant. His demands are always exorbitant
and he has never been willing to make any proposition for a complete and final
settlement. He seems to have the idea that the Yale should make monthly
payments on the water account, pay damages on hides each year as they are
injured, etc. If we ever began making payments on that basis there would be no
end to our difficulties. We therefore suggested to the Yale that we do nothing.
We feel that we would have a better opportunity to dispose of this claim if the
Packing Company obtained the services of a lawyer who could advise them with
reference to their rights, and the limits of the Yale's responsibilities.
On June 10, 1943, Lamey again wrote to the Maryland Casualty Co. with respect
to the matter of Yale's liability to Midland:
Since our letter of the 5th, we have held two conferences with
representatives of the Midland Empire Packing Company. The claimant has
employed M. J. Lamb of this city as attorney. At the conferences,
Mr. Frank Jacoby, a contractor, has also been present. It is our understanding
that he has some interest in the packing plant. However, we know him very well.
He is a competent and honest contractor.
Frank Jacoby was a construction contractor, who also did repair and
improvement work at various times for petitioner corporation. He owned
one-third of the capital stock of the petitioner throughout the period here
involved and later became vice president of the corporation. Jacoby talked with
the officers of Yale about the nature of the oil-sealing work to be done on
petitioner's plant in order to insure that the work was done to the satisfaction
of Yale, inasmuch as petitioner was looking for reimbursement for that amount
from Yale. Midland decided to proceed with the work in the basement and Yale
agreed that it should be done and that in any litigation or in any settlement
that ensued it would accept the testimony of Jacoby as to the reasonableness of
the cost of the work done. They also agreed to acknowledge the bills
for such work as an element of damages if a settlement was later effected. The
Yale officials refused to do the repair work themselves.
The president of Midland continued to refuse to give a complete release
covering future damage. The letter of June 10, 1943, recited some of the items
claimed by petitioner corporation, including several references to the repairs
in petitioner's basement.
With respect to the delay in giving the petitioner a definite answer to the
settlement of its liability, the letter stated:
It is rather difficult for the officers of the packing company to understand
why we cannot give an immediate definite answer, in view of the fact that the
offices of the Yale Petroleum Company are located in Billings. They have no
knowledge that there is insurance coverage. We mention this so that you will understand the importance of making some decision with reference to a basis of
settlement as soon as possible.
Finally, regarding the legal basis of Yale's liability to the petitioner for
the damages caused by the oil, Lamey wrote to the insurance company that it was
his opinion that Midland would have little difficulty in establishing
liability on the part of the Yale Oil Corporation. He also noted that the item
of damage claimed by the packing company could be considered as evidence of
damages. The letter then stated that, while the amount needed to settle the
claim might be large and the Yale Co. would not be able to get a release for
future damages, when the basement repairs were completed there should be little
future damage. He recommended that the claim be settled and concluded with a
statement that it was to Yale's advantage that Midland was proceeding with
repairs to the basement.
The original walls and floor of petitioner's plant were of concrete
construction. For the purpose of preventing oil from entering its
basement, petitioner added concrete lining to the walls from the floor to a
height of about four feet, and also added concrete to the floor of the basement.
Since the walls and floor had been thickened, petitioner now had less space in
which to operate. Petitioner had this work done by independent contractors,
supervised by Jacoby, in the fiscal year ended November 30, 1943, at a cost of $
4,868.81. Petitioner paid for this work during that year.
The oilproofing work was effective in sealing out the oil. While
it has served the purposes for which it was intended down to the present time,
it did not increase the useful life of the building or make the building more
valuable for any purpose than it had been before the oil had come into the
basement. The primary object of the oilproofing operation was to prevent the
seepage of oil into the basement so that the petitioner could use the basement
as before in preparing and packing meat for commercial consumption.
After the oilproofing was completed and prior to the close of the
petitioner's taxable year ended November 30, 1943, negotiations for settlement
were again conducted between representatives of petitioner and the Yale Oil
Corporation, at which time Yale offered to pay petitioner in cash the sum of
approximately $ 7,500 in satisfaction of all claims asserted by Midland against
Yale, provided Midland would execute a general release to Yale. Because Midland
was unwilling and refused to give such release for the payment offered, no
amount was in fact paid to petitioner by Yale in that year. Petitioner
continued to maintain that it was entitled to a much larger amount for the
general damage done to the plant by this nuisance. Negotiations had
reached this point in the fiscal year ended November 30, 1943.
The petitioner thereafter filed suit against Yale, on April 22, 1944, in a
cause of action sounding in tort and on November 30, 1944, joined as a defendant
in such action Yale's successor, the Carter Oil Co., which had acquired the
properties of Yale Oil Corporation. This action was to recover damages for the
nuisance created by the oil seepage. In those proceedings the defendants
demurred to the joinder of parties in the petitioner's complaint. On appeal,
the Montana Supreme Court sustained the demurrer.
Petitioner subsequently settled its cause of action against Yale for $
11,659.49 and gave Yale a complete release from all liability. This release was
dated October 23, 1946. The recovery of the cost of the waterproofing only
was reported in its excess profits and income tax returns for the year ended
November 30, 1946.
The petitioner is still making claim upon the Carter Oil Co. and is
endeavoring to settle that claim without suit.
Midland charged the $ 4,868.81 to repair expense on its regular books and
deducted that amount on its tax returns as an ordinary and
necessary business expense for the fiscal year 1943. The Commissioner, in his
notice of deficiency, determined that the cost of oilproofing was not
deductible, either as an ordinary and necessary expense or as a loss in 1943.
OPINION.
The issue in this case is whether an expenditure for a concrete lining in
petitioner's basement to oilproof it against an oil nuisance created by a
neighboring refinery is deductible as an ordinary and necessary expense under
section 23 (a) of the Internal Revenue Code, on the theory it was an expenditure
for a repair, or, in the alternative, whether the expenditure may be treated as
the measure of the loss sustained during the taxable year and not compensated
for by insurance or otherwise within the meaning of section 23 (f) of the
Internal Revenue Code.
The respondent has contended, in part, that the expenditure is for a capital
improvement and should be recovered through depreciation charges and is,
therefore, not deductible as an ordinary and necessary business expense or as a
loss.
It is none too easy to determine on which side of the line certain
expenditures fall so that they may be accorded their proper treatment for tax
purposes. Treasury Regulations 111, from which we quote in the
margin, is helpful in distinguishing between an expenditure to be classed as a
repair and one to be treated as a capital outlay. In Illinois Merchants Trust
Co., Executor, 4 B. T. A. 103, at page 106, we discussed this subject in some
detail and in our opinion said:
It will be noted that the first sentence of the article [now Regulations 111,
sec. 29.23 (a)-4] relates to repairs, while the second sentence deals in effect
with replacements. In determining whether an expenditure is a capital one or is
chargeable against operating income, it is necessary to bear in mind the purpose
for which the expenditure was made. To repair is to restore to a sound state or
to mend, while a replacement connotes a substitution. A repair is an
expenditure for the purpose of keeping the property in an ordinarily efficient
operating condition. It does not add to the value of the property, nor does it
appreciably prolong its life. It merely keeps the property in an operating
condition over its probable useful life for the uses for which it was acquired.
Expenditures for that purpose are distinguishable from those for
replacements, alterations, improvements, or additions which prolong the life of
the property, increase its value, or make it adaptable to a different use. The
one is a maintenance charge, while the others are additions to capital
investment which should not be applied against current earnings.
It will be seen from our findings of fact that for some 25 years
prior to the taxable year petitioner had used the basement rooms of
its plant as a place for the curing of hams and bacon and for the storage of
meat and hides. The basement had been entirely satisfactory for this purpose
over the entire period in spite of the fact that there was some seepage of water
into the rooms from time to time. In the taxable year it was found that not
only water, but oil, was seeping through the concrete walls of the basement of
the packing plant and, while the water would soon drain out, the oil would not,
and there was left on the basement floor a thick scum of oil which gave off a
strong odor that permeated the air of the entire plant, and the fumes from the
oil created a fire hazard. It appears that the oil which came from a nearby
refinery had also gotten into the water wells which served to furnish water for
petitioner's plant, and as a result of this whole condition the Federal meat
inspectors advised petitioner that it must discontinue the use of the water from
the wells and oilproof the basement, or else shut down its plant.
To meet this situation, petitioner during the taxable year undertook steps to
oilproof the basement by adding a concrete lining to the walls from the floor to
a height of about four feet and also added concrete to the floor of
the basement. It is the cost of this work which it seeks to deduct as a repair.
The basement was not enlarged by this work, nor did the oilproofing serve to
make it more desirable for the purpose for which it had been used through the
years prior to the time that the oil nuisance had occurred. The evidence is
that the expenditure did not add to the value or prolong the expected life of
the property over what they were before the event occurred which made the
repairs necessary. It is true that after the work was done the seepage of
water, as well as oil, was stopped, but, as already stated, the presence of the
water had never been found objectionable. The repairs merely served to keep the
property in an operating condition over its probable useful life for the purpose
for which it was used.
While it is conceded on brief that the expenditure was "necessary,"
respondent contends that the encroachment of the oil nuisance on petitioner's
property was not an "ordinary" expense in petitioner's particular business. But
the fact that petitioner had not theretofore been called upon to make a similar
expenditure to prevent damage and disaster to its property does not
remove that expense from the classification of "ordinary" for, as stated in
Welch v. Helvering, 290 U.S. 111, "ordinary in this context does not mean that
the payments must be habitual or normal in the sense that the same taxpayer will
have to make them often. * * * the expense is an ordinary one because we know
from experience that payments for such a purpose, whether the amount is large or
small, are the common and accepted means of defense against attack.
Cf. Kornhauser v. United States, 276 U.S. 145. The situation is unique in the
life of the individual affected, but not in the life of the group, the
community, of which he is a part." Steps to protect a business building from the
seepage of oil from a nearby refinery, which had been erected long subsequent to
the time petitioner started to operate its plant, would seem to us to be a
normal thing to do, and in certain sections of the country it must be a common
experience to protect one's property from the seepage of oil. Expenditures to
accomplish this result are likewise normal.
In American Bemberg Corporation, 10 T. C. 361, we allowed as
deductions, on the ground that they were ordinary and necessary expenses,
extensive expenditures made to prevent disaster, although the repairs were of a
type which had never been needed before and were unlikely to recur. In that
case the taxpayer, to stop cave-ins of soil which were threatening destruction
of its manufacturing plant, hired an engineering firm which drilled to the
bedrock and injected grout to fill the cavities where practicable, and made
incidental replacements and repairs, including tightening of the fluid carriers.
In two successive years the taxpayer expended $ 734,316.76 and $ 199,154.33,
respectively, for such drilling and grouting and $ 153,474.20 and $ 79,687.29,
respectively, for capital replacements. We found that the cost (other than
replacement) of this program did not make good the depreciation previously
allowed, and stated in our opinion:
In connection with the purpose of the work, the Proctor program was intended
to avert a plant-wide disaster and avoid forced abandonment of the plant. The
purpose was not to improve, better, extend, or increase the original plant, nor
to prolong its original useful life. Its continued operation was
endangered; the purpose of the expenditures was to enable petitioner to continue
the plant in operation not on any new or better scale, but on the same scale
and, so far as possible, as efficiently as it had operated before. The purpose
was not to rebuild or replace the plant in whole or in part, but to keep the
same plant as it was and where it was.
The petitioner here made the repairs in question in order that it might
continue to operate its plant. Not only was there danger of fire from the oil
and fumes, but the presence of the oil led the Federal meat inspectors to
declare the basement an unsuitable place for the purpose for which it had been
used for a quarter of a century. After the expenditures were made, the plant
did not operate on a changed or larger scale, nor was it thereafter suitable for
new or additional uses. The expenditure served only to permit petitioner to
continue the use of the plant, and particularly the basement for its normal
operations.
In our opinion, the expenditure of $ 4,868.81 for lining the basement walls
and floor was essentially a repair and, as such, it is deductible as
an ordinary and necessary business expense. This holding makes
unnecessary a consideration of petitioner's alternative contention that the
expenditure is deductible as a business loss, nor need we heed the respondent's
argument that any loss suffered was compensated for by "insurance or otherwise."
Mt. Morris Drive-In Theatre Co., Petitioner, v. Commissioner
of Internal Revenue, Respondent
Docket No. 49542
UNITED STATES TAX COURT
25 T.C. 272
November 18, 1955, Filed
DISPOSITION:
Decision will be entered for the respondent.
SYLLABUS: Petitioner constructed an open-air theatre on sloping land formerly
covered with vegetation without including in the construction any drainage
system. In 1950 it spent $ 8,224 to construct a drainage system extending into
and over adjacent land belonging to another in compromise of a pending lawsuit
against it based upon allegations that petitioner's use of its own property had
caused accelerated and concentrated drainage onto the adjacent land. Held, the
cost of the drainage system was a capital expenditure and was not deductible
either as an ordinary and necessary business expense or as a loss.
OPINIONBY: KERN
OPINION: The Commissioner determined a deficiency in the petitioner's
income and excess profits tax for 1950 in the amount of $ 3,150.13. The only
issue for decision is whether the amount of $ 8,224 spent by the petitioner in
1950 to construct a drainage system was deductible either as an
ordinary and necessary business expense or as a loss, as contended by the
petitioner, or whether it was a nondepreciable capital expenditure, as
determined by the Commissioner. An alternative issue raised by the petitioner
that the cost of the drainage system should be amortized over a period of at
least 5 years was expressly abandoned by it at the hearing.
FINDINGS OF FACT.
The petitioner is an Ohio corporation with its principal offices in
Cleveland, Ohio. It filed an original and an amended Federal income and excess
profits tax return for the calendar year 1950 with the collector of internal
revenue for the eighteenth district of Ohio.
In 1947 petitioner purchased 13 acres of farm land located on the outskirts
of Flint, Michigan, upon which it proceeded to construct a drive-in or outdoor
theatre. Prior to its purchase by the petitioner the land on which the theatre
was built was farm land and contained vegetation. The slope of the land was
such that the natural drainage of water was from the southerly line to the
northerly boundary of the property and thence onto the adjacent land, owned by
David and Mary D. Nickola, which was used both for farming
and as a trailer park. The petitioner's land sloped sharply from south to north
and also sloped from the east downward towards the west so that most of the
drainage from the petitioner's property was onto the southwest corner of the
Nickolas' land. The topography of the land purchased by petitioner was well
known to petitioner at the time it was purchased and developed. The petitioner
did not change the general slope of its land in constructing the drive-in
theatre, but it removed the covering vegetation from the land, slightly
increased the grade, and built aisles or ramps which were covered with gravel
and were somewhat raised so that the passengers in the automobiles would be able
to view the picture on the large outdoor screen.
As a result of petitioner's construction on and use of this land rain water
falling upon it drained with an increased flow into and upon the adjacent
property of the Nickolas. This result should reasonably have been anticipated
by petitioner at the time when the construction work was done.
The Nickolas complained to the petitioner at various times after petitioner
began the construction of the theatre that the work resulted in an
acceleration and concentration of the flow of water which drained from the
petitioner's property onto the Nickolas' land causing damage to their crops and
roadways. On or about October 11, 1948, the Nickolas filed a suit against the
petitioner in the Circuit Court for the County of Genesee, State of Michigan,
asking for an award for damages done to their property by the accelerated and
concentrated drainage of the water and for a permanent injunction restraining
the defendant from permitting such drainage to continue. Following the filing
of an answer by the petitioner and of a reply thereto by the Nickolas, the suit
was settled by an agreement dated June 27, 1950. This agreement provided for
the construction by the petitioner of a drainage system to carry water from its
northern boundary across the Nickolas' property and thence to a public drain.
The cost of maintaining the system was to be shared by the petitioner and the
Nickolas, and the latter granted the petitioner and its successors an easement
across their land for the purpose of constructing and maintaining the drainage
system. The construction of the drain was completed in October 1950 under the
supervision of engineers employed by the petitioner and the Nickolas at
a cost to the petitioner of $ 8,224, which amount was paid by it in November
1950. The performance by the petitioner on its part of the agreement to
construct the drainage system and to maintain the portion for which it was
responsible constituted a full release of the Nickolas' claims against it. The
petitioner chose to settle the dispute by constructing the drainage system
because it did not wish to risk the possibility that continued litigation might
result in a permanent injunction against its use of the drive-in
theatre and because it wished to eliminate the cause of the friction between it
and the adjacent landowners, who were in a position to seriously interfere
with the petitioner's use of its property for outdoor theatre purposes. A
settlement based on a monetary payment for past damages, the petitioner
believed, would not remove the threat of claims for future damages.
On its 1950 income and excess profits tax return the petitioner claimed a
deduction of $ 822.40 for depreciation of the drainage system for the period
July 1, 1950, to December 31, 1950. The Commissioner disallowed without
itemization $ 5,514.60 of a total depreciation expense deduction of $
19,326.41 claimed by the petitioner. In its petition the petitioner asserted
that the entire amount spent to construct the drainage system was fully
deductible in 1950 as an ordinary and necessary business expense incurred in the
settlement of a lawsuit, or, in the alternative, as a loss, and claimed a refund
of part of the $ 10,591.56 of income and excess profits tax paid by it for that
year.
The drainage system was a permanent improvement to the petitioner's property,
and the cost thereof constituted a capital expenditure.
The stipulation of facts and the exhibits annexed thereto are incorporated
herein by this reference.
OPINION.
When petitioner purchased, in 1947, the land which it intended to use for a
drive-in theatre, its president was thoroughly familiar with the topography of
this land which was such that when the covering vegetation was removed and
graveled ramps were constructed and used by its patrons, the flow of natural
precipitation on the lands of abutting property owners would be materially
accelerated. Some provision should have been made to solve this drainage
problem in order to avoid annoyance and harrassment to its neighbors.
If petitioner had included in its original construction plans an expenditure for
a proper drainage system no one could doubt that such an expenditure would have
been capital in nature.
Within a year after petitioner had finished its inadequate construction of
the drive-in theatre, the need of a proper drainage system was forcibly called
to its attention by one of the neighboring property owners, and under the threat
of a lawsuit filed approximately a year after the theatre was constructed, the
drainage system was built by petitioner who now seeks to deduct its cost as an
ordinary and necessary business expense, or as a loss.
We agree with respondent that the cost to petitioner of acquiring and
constructing a drainage system in connection with its drive-in theatre was a
capital expenditure.
Here was no sudden catastrophic loss caused by a "physical fault" undetected
by the taxpayer in spite of due precautions taken by it at the time
of its original construction work as in American Bemberg Corporation, 10 T. C.
361; no unforeseeable external factor as in Midland Empire Packing Co., 14 T. C.
635; and no change in the cultivation of farm property caused by
improvements in technique and made many years after the property in question was
put to productive use as in J. H. Collingwood, 20 T. C. 937. In the instant case
it was obvious at the time when the drive-in theatre was constructed, that a
drainage system would be required to properly dispose of the natural
precipitation normally to be expected, and that until this was accomplished,
petitioner's capital investment was incomplete. In addition, it should be
emphasized that here there was no mere restoration or rearrangement of the
original capital asset, but there was the acquisition and construction of a
capital asset which petitioner had not previously had, namely, a new drainage
system.
That this drainage system was acquired and constructed and that payments
therefor were made in compromise of a lawsuit is not determinative of whether
such payments were ordinary and necessary business expenses or capital
expenditures. "The decisive test is still the character of the transaction
which gives rise to the payment." Hales-Mullaly v. Commissioner, 131 F. 2d 509,
511, 512.
In our opinion the character of the transaction in the instant case indicates
that the transaction was a capital expenditure.
Decision will be entered for the respondent.