What Is Gross Income: Section 61 and the Sixteenth Amendment

Chapter 2



What Is Gross Income: Section 61 and the Sixteenth Amendment


Recall the “tax formula” in chapter 1. Now we take up various elements of the formula. You should place whatever we are studying at the moment (the “trees”) within that formula (the “forest”). This chapter introduces you to the concept of “gross income,” the very first item in the tax formula.


You will notice that after adding up all of the items encompassed by the phrase “gross income,” every succeeding arithmetical operation is a subtraction. If an item is not encompassed by the phrase “gross income,” it will not be subject to federal income tax. The materials that follow consider various aspects of gross income: its definition, whether certain items that taxpayer has received constitute “gross income,” the timing of “gross income,” and valuation.




The Tax Formula:


→ (gross income)


MINUS deductions named in § 62


EQUALS (adjusted gross income (AGI))


MINUS (standard deduction or itemized deductions)


MINUS (personal exemptions)


EQUALS (taxable income)


Compute income tax liability from tables in § 1 (indexed for inflation)


MINUS (credits against tax)





CALI Lesson Logo


Do the CALI lessons, Basic Income Taxation: Gross Income: Realization Concepts in Gross Income and Basic Income Taxation: Gross Income: Indirect Transfers for Services. These are fairly short Lessons that you may do several times as we cover this chapter.


I. The Constitutional and Statutory Definitions of “Gross Income”



Article I of the Constitution, which grants legislative powers to the Congress, contains several provisions concerning federal taxes.


Article I, § 2, clause 3: Representatives and direct Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers, which shall be determined by adding to the whole Number of free Persons, including those bound to Service for a Term of Years, and excluding Indians not taxed, three fifths of all other Persons. The actual Enumeration shall be made within three Years after the first Meeting of the Congress of the United States, and within every subsequent Term of ten Years, in such Manner as they shall by Law direct. …


Article I, § 7, clause 1: All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills.


Article I, § 8, clause 1: The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States[.]


Article I, § 9, clause 4: No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.


The Constitution does not delegate to any other branch of the government any authority to impose taxes. In Article I, § 9, cl. 4, the Constitution refers to “direct” taxes, and restricts them to impositions upon states according to their population. The founding fathers regarded consumption taxes as “indirect taxes” and regarded them as superior to “direct taxes” in terms of fairness and for purposes of raising revenue. See Alexander Hamilton, Federalist No. 21.


An income tax is a “direct tax.” Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 601, 630 (1895) (tax on income from property). Imposition of an income tax required an amendment to the Constitution. That came in 1913:


Amendment 16: The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.


Read § 61(a) of the Code. Notice that it encompasses “all” income “from whatever source derived.” The language of the Code tracks that of the Sixteenth Amendment, and it has been noted many times that in taxing income, Congress exercised all of the constitutional power that it has to do so. However, that point left open the question of what exactly is “income[], from whatever source derived.” Taxpayers have argued many times that the “income” that Congress wants to tax is beyond the scope of “income” as the term is used in the Sixteenth Amendment. See Ann K. Wooster, Annot., Application of 16th Amendment to U.S. Constitution – Taxation of Specific Types of Income, 40 A.L.R. Fed.2d 301 (2010).


We consider here two cases in which the Supreme Court undertook to provide a definition of “gross income,” the phrase that Congress used in § 61(a). In Macomber, notice the justices’ differing views on the internal accounting of a corporation.


• What does the Court mean by “capitalization?”


• What does the Court mean by “surplus?”


• By way of review: a demurrer is a creature of code pleading and is the equivalent of a motion to dismiss for failure to state a claim. In Macomber, taxpayer sued for a refund. The Commissioner (Eisner) demurred. The federal district court overruled the demurrer, so taxpayer-plaintiff prevailed. The Supreme Court affirmed.


Eisner v. Macomber, 252 U.S. 189 (1919)



MR. JUSTICE PITNEY delivered the opinion of the Court.


This case presents the question whether, by virtue of the Sixteenth Amendment, Congress has the power to tax, as income of the stockholder and without apportionment, a stock dividend made lawfully and in good faith against profits accumulated by the corporation since March 1, 1913.


It arises under the Revenue Act of September 8, 1916, 39 Stat. 756 et seq., which, in our opinion (notwithstanding a contention of the government that will be noticed), plainly evinces the purpose of Congress to tax stock dividends as income.29



The facts, in outline, are as follows:


On January 1, 1916, the Standard Oil Company of California, a corporation of that state, out of an authorized capital stock of $100,000,000, had shares of stock outstanding, par value $100 each, amounting in round figures to $50,000,000. In addition, it had surplus and undivided profits invested in plant, property, and business and required for the purposes of the corporation, amounting to about $45,000,000, of which about $20,000,000 had been earned prior to March 1, 1913, the balance thereafter. In January, 1916, in order to readjust the capitalization, the board of directors decided to issue additional shares sufficient to constitute a stock dividend of 50 percent of the outstanding stock, and to transfer from surplus account to capital stock account an amount equivalent to such issue. …


Defendant in error, being the owner of 2,200 shares of the old stock, received certificates for 1,100 additional shares, of which 18.07 percent, or 198.77 shares, par value $19,877, were treated as representing surplus earned between March 1, 1913, and January 1, 1916. She was called upon to pay, and did pay under protest, a tax imposed under the Revenue Act of 1916, based upon a supposed income of $19,877 because of the new shares, and, an appeal to the Commissioner of Internal Revenue having been disallowed, she brought action against the Collector to recover the tax. In her complaint, she alleged the above facts and contended that, in imposing such a tax the Revenue Act of 1916 violated article 1, § 2, cl. 3, and Article I, § 9, cl. 4, of the Constitution of the United States, requiring direct taxes to be apportioned according to population, and that the stock dividend was not income within the meaning of the Sixteenth Amendment. A general demurrer to the complaint was overruled upon the authority of Towne v. Eisner, 245 U. S. 418, and, defendant having failed to plead further, final judgment went against him. To review it, the present writ of error is prosecuted.




We are constrained to hold that the judgment of the district court must be affirmed[.] …




[I]n view of the importance of the matter, and the fact that Congress in the Revenue Act of 1916 declared (39 Stat. 757) that a “stock dividend shall be considered income, to the amount of its cash value,” we will deal at length with the constitutional question, incidentally testing the soundness of our previous conclusion.


The Sixteenth Amendment … did not extend the taxing power to new subjects, but merely removed the necessity which otherwise might exist for an apportionment among the states of taxes laid on income. Brushaber v. Union Pacific R. Co., 240 U. S. 1, 240 U. S. 17-19; Stanton v. Baltic Mining Co., 240 U. S. 103, 240 U. S. 112 et seq.; Peck & Co. v. Lowe, 247 U. S. 165, 247 U. S. 172-173.


A proper regard for its genesis, as well as its very clear language, requires also that this amendment shall not be extended by loose construction, so as to repeal or modify, except as applied to income, those provisions of the Constitution that require an apportionment according to population for direct taxes upon property, real and personal. This limitation still has an appropriate and important function, and is not to be overridden by Congress or disregarded by the courts.


In order, therefore, that … Article I of the Constitution may have proper force and effect, save only as modified by the amendment, and that the latter also may have proper effect, it becomes essential to distinguish between what is and what is not “income,” as the term is there used, and to apply the distinction, as cases arise, according to truth and substance, without regard to form. Congress cannot by any definition it may adopt conclude the matter, since it cannot by legislation alter the Constitution, from which alone it derives its power to legislate, and within whose limitations alone that power can be lawfully exercised.


The fundamental relation of “capital” to “income” has been much discussed by economists, the former being likened to the tree or the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from springs, the latter as the outlet stream, to be measured by its flow during a period of time. For the present purpose, we require only a clear definition of the term “income,” as used in common speech, in order to determine its meaning in the amendment, and, having formed also a correct judgment as to the nature of a stock dividend, we shall find it easy to decide the matter at issue.


After examining dictionaries in common use (Bouv. L.D.; Standard Dict.; Webster’s Internat. Dict.; Century Dict.), we find little to add to the succinct definition adopted in two cases arising under the Corporation Tax Act of 1909 (Stratton’s Independence v. Howbert, 231 U. S. 399, 231 U. S. 415; Doyle v. Mitchell Bros. Co., 247 U. S. 179, 247 U. S. 185), “Income may be defined as the gain derived from capital, from labor, or from both combined,” provided it be understood to include profit gained through a sale or conversion of capital assets …


Brief as it is, it indicates the characteristic and distinguishing attribute of income essential for a correct solution of the present controversy. The government, although basing its argument upon the definition as quoted, placed chief emphasis upon the word “gain,” which was extended to include a variety of meanings; while the significance of the next three words was either overlooked or misconceived. “Derived from capital;” “the gain derived from capital,” etc. Here, we have the essential matter: not a gain accruing to capital; not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and coming in, being “derived” – that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal – that is income derived from property. Nothing else answers the description.


The same fundamental conception is clearly set forth in the Sixteenth Amendment – “incomes, from whatever source derived” – the essential thought being expressed with a conciseness and lucidity entirely in harmony with the form and style of the Constitution.


Can a stock dividend, considering its essential character, be brought within the definition? To answer this, regard must be had to the nature of a corporation and the stockholder’s relation to it. We refer, of course, to a corporation such as the one in the case at bar, organized for profit, and having a capital stock divided into shares to which a nominal or par value is attributed.


Certainly the interest of the stockholder is a capital interest, and his certificates of stock are but the evidence of it. They state the number of shares to which he is entitled and indicate their par value and how the stock may be transferred. They show that he or his assignors, immediate or remote, have contributed capital to the enterprise, that he is entitled to a corresponding interest proportionate to the whole, entitled to have the property and business of the company devoted during the corporate existence to attainment of the common objects, entitled to vote at stockholders’ meetings, to receive dividends out of the corporation’s profits if and when declared, and, in the event of liquidation, to receive a proportionate share of the net assets, if any, remaining after paying creditors. Short of liquidation, or until dividend declared, he has no right to withdraw any part of either capital or profits from the common enterprise; on the contrary, his interest pertains not to any part, divisible or indivisible, but to the entire assets, business, and affairs of the company. Nor is it the interest of an owner in the assets themselves, since the corporation has full title, legal and equitable, to the whole. The stockholder has the right to have the assets employed in the enterprise, with the incidental rights mentioned; but, as stockholder, he has no right to withdraw, only the right to persist, subject to the risks of the enterprise, and looking only to dividends for his return. If he desires to dissociate himself from the company, he can do so only by disposing of his stock.


For bookkeeping purposes, the company acknowledges a liability in form to the stockholders equivalent to the aggregate par value of their stock, evidenced by a “capital stock account.” If profits have been made and not divided, they create additional bookkeeping liabilities under the head of “profit and loss,” “undivided profits,” “surplus account,” or the like. None of these, however, gives to the stockholders as a body, much less to any one of them, either a claim against the going concern for any particular sum of money or a right to any particular portion of the assets or any share in them unless or until the directors conclude that dividends shall be made and a part of the company’s assets segregated from the common fund for the purpose. The dividend normally is payable in money, under exceptional circumstances in some other divisible property, and when so paid, then only (excluding, of course, a possible advantageous sale of his stock or winding-up of the company) does the stockholder realize a profit or gain which becomes his separate property, and thus derive income from the capital that he or his predecessor has invested.


In the present case, the corporation had surplus and undivided profits invested in plant, property, and business, and required for the purposes of the corporation, amounting to about $45,000,000, in addition to outstanding capital stock of $50,000,000. In this, the case is not extraordinary. The profits of a corporation, as they appear upon the balance sheet at the end of the year, need not be in the form of money on hand in excess of what is required to meet current liabilities and finance current operations of the company. Often, especially in a growing business, only a part, sometimes a small part, of the year’s profits is in property capable of division, the remainder having been absorbed in the acquisition of increased plant, equipment, stock in trade, or accounts receivable, or in decrease of outstanding liabilities. When only a part is available for dividends, the balance of the year’s profits is carried to the credit of undivided profits, or surplus, or some other account having like significance. If thereafter the company finds itself in funds beyond current needs, it may declare dividends out of such surplus or undivided profits; otherwise it may go on for years conducting a successful business, but requiring more and more working capital because of the extension of its operations, and therefore unable to declare dividends approximating the amount of its profits. Thus, the surplus may increase until it equals or even exceeds the par value of the outstanding capital stock. This may be adjusted upon the books in the mode adopted in the case at bar – by declaring a “stock dividend.” This, however, is no more than a book adjustment, in essence – not a dividend, but rather the opposite; no part of the assets of the company is separated from the common fund, nothing distributed except paper certificates that evidence an antecedent increase in the value of the stockholder’s capital interest resulting from an accumulation of profits by the company, but profits so far absorbed in the business as to render it impracticable to separate them for withdrawal and distribution. In order to make the adjustment, a charge is made against surplus account with corresponding credit to capital stock account, equal to the proposed “dividend;” the new stock is issued against this and the certificates delivered to the existing stockholders in proportion to their previous holdings. This, however, is merely bookkeeping that does not affect the aggregate assets of the corporation or its outstanding liabilities; it affects only the form, not the essence, of the “liability” acknowledged by the corporation to its own shareholders, and this through a readjustment of accounts on one side of the balance sheet only, increasing “capital stock” at the expense of “surplus”; it does not alter the preexisting proportionate interest of any stockholder or increase the intrinsic value of his holding or of the aggregate holdings of the other stockholders as they stood before. The new certificates simply increase the number of the shares, with consequent dilution of the value of each share.


A “stock dividend” shows that the company’s accumulated profits have been capitalized, instead of distributed to the stockholders or retained as surplus available for distribution in money or in kind should opportunity offer. Far from being a realization of profits of the stockholder, it tends rather to postpone such realization, in that the fund represented by the new stock has been transferred from surplus to capital, and no longer is available for actual distribution.


The essential and controlling fact is that the stockholder has received nothing out of the company’s assets for his separate use and benefit; on the contrary, every dollar of his original investment, together with whatever accretions and accumulations have resulted from employment of his money and that of the other stockholders in the business of the company, still remains the property of the company, and subject to business risks which may result in wiping out the entire investment. Having regard to the very truth of the matter, to substance and not to form, he has received nothing that answers the definition of income within the meaning of the Sixteenth Amendment.




We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is the richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction.


It is said that a stockholder may sell the new shares acquired in the stock dividend, and so he may, if he can find a buyer. It is equally true that, if he does sell, and in doing so realizes a profit, such profit, like any other, is income, and, so far as it may have arisen since the Sixteenth Amendment, is taxable by Congress without apportionment. The same would be true were he to sell some of his original shares at a profit. But if a shareholder sells dividend stock, he necessarily disposes of a part of his capital interest, just as if he should sell a part of his old stock, either before or after the dividend. What he retains no longer entitles him to the same proportion of future dividends as before the sale. His part in the control of the company likewise is diminished. Thus, if one holding $60,000 out of a total $100,000 of the capital stock of a corporation should receive in common with other stockholders a 50 percent stock dividend, and should sell his part, he thereby would be reduced from a majority to a minority stockholder, having six-fifteenths instead of six-tenths of the total stock outstanding. A corresponding and proportionate decrease in capital interest and in voting power would befall a minority holder should he sell dividend stock, it being in the nature of things impossible for one to dispose of any part of such an issue without a proportionate disturbance of the distribution of the entire capital stock and a like diminution of the seller’s comparative voting power – that “right preservative of rights” in the control of a corporation. Yet, without selling, the shareholder, unless possessed of other resources, has not the wherewithal to pay an income tax upon the dividend stock. Nothing could more clearly show that to tax a stock dividend is to tax a capital increase, and not income, than this demonstration that, in the nature of things, it requires conversion of capital in order to pay the tax.




Conceding that the mere issue of a stock dividend makes the recipient no richer than before, the government nevertheless contends that the new certificates measure the extent to which the gains accumulated by the corporation have made him the richer. There are two insuperable difficulties with this. In the first place, it would depend upon how long he had held the stock whether the stock dividend indicated the extent to which he had been enriched by the operations of the company; unless he had held it throughout such operations, the measure would not hold true. Secondly, and more important for present purposes, enrichment through increase in value of capital investment is not income in any proper meaning of the term.




It is said there is no difference in principle between a simple stock dividend and a case where stockholders use money received as cash dividends to purchase additional stock contemporaneously issued by the corporation. But an actual cash dividend, with a real option to the stockholder either to keep the money for his own or to reinvest it in new shares, would be as far removed as possible from a true stock dividend, such as the one we have under consideration, where nothing of value is taken from the company’s assets and transferred to the individual ownership of the several stockholders and thereby subjected to their disposal.




Thus, from every point of view, we are brought irresistibly to the conclusion that neither under the Sixteenth Amendment nor otherwise has Congress power to tax without apportionment a true stock dividend made lawfully and in good faith, or the accumulated profits behind it, as income of the stockholder. The Revenue Act of 1916, insofar as it imposes a tax upon the stockholder because of such dividend, contravenes the provisions of Article I, § 2, cl. 3, and Article I, § 9, cl. 4, of the Constitution, and to this extent is invalid notwithstanding the Sixteenth Amendment.


Judgment affirmed.


Mr. Justice Holmes, dissenting. [omitted]


MR. JUSTICE BRANDEIS delivered the following opinion, in which MR. JUSTICE CLARKE concurred.


Financiers, with the aid of lawyers, devised long ago two different methods by which a corporation can, without increasing its indebtedness, keep for corporate purposes accumulated profits, and yet, in effect, distribute these profits among its stockholders. One method is a simple one. The capital stock is increased; the new stock is paid up with the accumulated profits, and the new shares of paid-up stock are then distributed among the stockholders pro rata as a dividend. If the stockholder prefers ready money to increasing his holding of the stock in the company, he sells the new stock received as a dividend. The other method is slightly more complicated. Arrangements are made for an increase of stock to be offered to stockholders pro rata at par, and at the same time for the payment of a cash dividend equal to the amount which the stockholder will be required to pay to the company, if he avails himself of the right to subscribe for his pro rata of the new stock. If the stockholder takes the new stock, as is expected, he may endorse the dividend check received to the corporation, and thus pay for the new stock. In order to ensure that all the new stock so offered will be taken, the price at which it is offered is fixed far below what it is believed will be its market value. If the stockholder prefers ready money to an increase of his holdings of stock, he may sell his right to take new stock pro rata, which is evidenced by an assignable instrument. In that event the purchaser of the rights repays to the corporation, as the subscription price of the new stock, an amount equal to that which it had paid as a cash dividend to the stockholder.


Both of these methods of retaining accumulated profits while in effect distributing them as a dividend had been in common use in the United States for many years prior to the adoption of the Sixteenth Amendment. They were recognized equivalents. …




It thus appears that, among financiers and investors, the distribution of the stock, by whichever method effected, is called a stock dividend; that the two methods by which accumulated profits are legally retained for corporate purposes and at the same time distributed as dividends are recognized by them to be equivalents, and that the financial results to the corporation and to the stockholders of the two methods are substantially the same, unless a difference results from the application of the federal income tax law.




It is conceded that, if the stock dividend paid to Mrs. Macomber had been made by the more complicated method [of] issuing rights to take new stock pro rata and paying to each stockholder simultaneously a dividend in cash sufficient in amount to enable him to pay for this pro rata of new stock to be purchased – the dividend so paid to him would have been taxable as income, whether he retained the cash or whether he returned it to the corporation in payment for his pro rata of new stock. But it is contended that, because the simple method was adopted of having the new stock issued direct to the stockholders as paid-up stock, the new stock is not to be deemed income, whether she retained it or converted it into cash by sale. If such a different result can flow merely from the difference in the method pursued, it must be because Congress is without power to tax as income of the stockholder either the stock received under the latter method or the proceeds of its sale, for Congress has, by the provisions in the Revenue Act of 1916, expressly declared its purpose to make stock dividends, by whichever method paid, taxable as income.




… Is there anything in the phraseology of the Sixteenth Amendment or in the nature of corporate dividends which should lead to a [conclusion] … that Congress is powerless to prevent a result so extraordinary as that here contended for by the stockholder?


First. The term “income,” when applied to the investment of the stockholder in a corporation, had, before the adoption of the Sixteenth Amendment, been commonly understood to mean the returns from time to time received by the stockholder from gains or earnings of the corporation. A dividend received by a stockholder from a corporation may be either in distribution of capital assets or in distribution of profits. Whether it is the one or the other is in no way affected by the medium in which it is paid, nor by the method or means through which the particular thing distributed as a dividend was procured. If the dividend is declared payable in cash, the money with which to pay it is ordinarily taken from surplus cash in the treasury. …


… [W]hether a dividend declared payable from profits shall be paid in cash or in some other medium is also wholly a matter of financial management. If some other medium is decided upon, it is also wholly a question of financial management whether the distribution shall be, for instance, in bonds, scrip or stock of another corporation or in issues of its own. And if the dividend is paid in its own issues, why should there be a difference in result dependent upon whether the distribution was made from such securities then in the treasury or from others to be created and issued by the company expressly for that purpose? So far as the distribution may be made from its own issues of bonds, or preferred stock created expressly for the purpose, it clearly would make no difference, in the decision of the question whether the dividend was a distribution of profits, that the securities had to be created expressly for the purpose of distribution. If a dividend paid in securities of that nature represents a distribution of profits, Congress may, of course, tax it as income of the stockholder. Is the result different where the security distributed is common stock?




Second. It has been said that a dividend payable in bonds or preferred stock created for the purpose of distributing profits may be income and taxable as such, but that the case is different where the distribution is in common stock created for that purpose. Various reasons are assigned for making this distinction. One is that the proportion of the stockholder’s ownership to the aggregate number of the shares of the company is not changed by the distribution. But that is equally true where the dividend is paid in its bonds or in its preferred stock. Furthermore, neither maintenance nor change in the proportionate ownership of a stockholder in a corporation has any bearing upon the question here involved. Another reason assigned is that the value of the old stock held is reduced approximately by the value of the new stock received, so that the stockholder, after receipt of the stock dividend, has no more than he had before it was paid. That is equally true whether the dividend be paid in cash or in other property – for instance, bonds, scrip, or preferred stock of the company. The payment from profits of a large cash dividend, and even a small one, customarily lowers the then market value of stock because the undivided property represented by each share has been correspondingly reduced. The argument which appears to be most strongly urged for the stockholders is that, when a stock dividend is made, no portion of the assets of the company is thereby segregated for the stockholder. But does the issue of new bonds or of preferred stock created for use as a dividend result in any segregation of assets for the stockholder? In each case, he receives a piece of paper which entitles him to certain rights in the undivided property. Clearly, segregation of assets in a physical sense is not an essential of income. The year’s gains of a partner is [sic] taxable as income although there, likewise, no segregation of his share in the gains from that of his partners is had.




Third. The government urges that it would have been within the power of Congress to have taxed as income of the stockholder his pro rata share of undistributed profits earned even if no stock dividend representing it had been paid. Strong reasons may be assigned for such a view. [citation omitted]. The undivided share of a partner in the year’s undistributed profits of his firm is taxable as income of the partner although the share in the gain is not evidenced by any action taken by the firm. Why may not the stockholder’s interest in the gains of the company? The law finds no difficulty in disregarding the corporate fiction whenever that is deemed necessary to attain a just result. [citations omitted]. The stockholder’s interest in the property of the corporation differs not fundamentally, but in form only, from the interest of a partner in the property of the firm. There is much authority for the proposition that, under our law, a partnership or joint stock company is just as distinct and palpable an entity in the idea of the law, as distinguished from the individuals composing it, as is a corporation. No reason appears, why Congress, in legislating under a grant of power so comprehensive as that authorizing the levy of an income tax, should be limited by the particular view of the relation of the stockholder to the corporation and its property which may, in the absence of legislation, have been taken by this Court. But we have no occasion to decide the question whether Congress might have taxed to the stockholder his undivided share of the corporation’s earnings. For Congress has in this act limited the income tax to that share of the stockholder in the earnings which is, in effect, distributed by means of the stock dividend paid. In other words, to render the stockholder taxable, there must be both earnings made and a dividend paid. Neither earnings without dividend nor a dividend without earnings subjects the stockholder to taxation under the Revenue Act of 1916.


Fourth. …


Fifth. …






Capital and Surplus: The opinions in this case provide a primer on corporation law. A corporation’s shareholders are its owners. They pay money (or transfer other property) to the corporation to purchase shares that represent ownership of the corporation’s productive capital. Once the corporation begins to operate, it earns profits. The corporation might choose not to retain these profits but rather to distribute them profits to its shareholders as dividends. Alternatively, the corporation might not distribute the profits. Instead, it might hold the profits for later distribution and/or use the profits to acquire still more productive capital assets. Corporation law required that the “capital stock account” and the “surplus account” be separately accounted for.


• Sections 301 and 316 still implement this scheme. Dividends are taxable as income to a shareholder only if a corporation pays them from “earnings and profits.”





Sixth. If stock dividends representing profits are held exempt from taxation under the Sixteenth Amendment, the owners of the most successful businesses in America will, as the facts in this case illustrate, be able to escape taxation on a large part of what is actually their income. So far as their profits are represented by stock received as dividends, they will pay these taxes not upon their income, but only upon the income of their income. That such a result was intended by the people of the United States when adopting the Sixteenth Amendment is inconceivable. Our sole duty is to ascertain their intent as therein expressed. In terse, comprehensive language befitting the Constitution, they empowered Congress “to lay and collect taxes on incomes from whatever source derived.” They intended to include thereby everything which by reasonable understanding can fairly be regarded as income. That stock dividends representing profits are so regarded not only by the plain people, but by investors and financiers and by most of the courts of the country, is shown beyond peradventure by their acts and by their utterances. It seems to me clear, therefore, that Congress possesses the power which it exercised to make dividends representing profits taxable as income whether the medium in which the dividend is paid be cash or stock, and that it may define, as it has done, what dividends representing profits shall be deemed income. It surely is not clear that the enactment exceeds the power granted by the Sixteenth Amendment. …


Notes and Questions:


1. In Macomber, consider the different views of the excerpted opinions of a corporation. Recall that under the SHS definition of income, an addition to an investment is taxable income, but a mere change in the form in which wealth is held is not a taxable event. Consider how the two opinions implicitly30 handle these points. Is one view better than the other? Why?



2. If ten shareholders each contribute $100,000 upon the formation of a corporation so that the corporation’s paid-in capital is $1M and two years later the fair market value (fmv) of the corporation’s assets has not changed but the corporation has accumulated undistributed profits of $200,000, what would be the fmv of each shareholder’s shares?


• Is it even possible to avoid merging the capital and profits accounts of a corporation when considering whether a shareholder has enjoyed an increment to his/her consumption rights?


• Should each shareholder pay income tax on a share’s increased fmv if the corporation does not distribute the profits?




Substance and Form: The argument of Justice Brandeis that two methods that accomplish the same thing should bear the same tax consequences – i.e., that substance should prevail over form – applies on many occasions in tax law. However, tax law does not treat the two methods he describes in the first paragraph of his opinion by which a corporation can in effect distribute its accumulated profits without increasing its indebtedness as “equivalent.” §§ 305(a), 305(b)(1).


• Moreover, the law of corporate tax does not treat equity interests (stock) and creditor interests (debt) as equivalent – and so treats distributions of stock and debt differently.





3. Does the concept of realization determine when taxpayer may spend an increment to his/her consumption rights on consumption as s/he sees fit? If the corporation will not pay out undistributed profits, why can’t the shareholder simply borrow against his/her share of the undistributed profits? The interest taxpayer must pay is simply the (nominal?) cost of spending money that s/he “owns” but is not entitled to receive.


4. What exactly is the holding of the majority with respect to the meaning of “income” under the Sixteenth Amendment? Which of the following are critical?


• That shareholder did not “realize” any income and that without realization, there is no “income?”


• That shareholder did not receive any property for his/her use and benefit and that in the absence of such receipt, there is no “income?”


• That a corporation’s undistributed accumulations do not constitute “income” to a shareholder?


• That if the corporation does not segregate particular assets for the shareholder, there is no “income?”


• That shareholder’s receipt of shares did not alter his/her underlying interest in the corporation or make him/her richer, so the receipt of such shares is not “income” within the Sixteenth Amendment?




The Corporation as Separate Entity: The most important point of any dissent is that it is a dissent. Notice that Justice Brandeis would tax shareholders in the same manner that partners in a partnership are taxed on undistributed earnings. His view did not prevail. This fact firmly established the identity of a corporation as separate from its shareholders – unlike a partnership and its partners.





5. This case is often said to stand for the proposition that “income” within the Sixteenth Amendment must be “realized?” True?


6. Justice Brandeis’s parade of horribles has come to pass. We tax dividends differently depending on how they are distributed. § 305. We tax partners on undistributed income but not corporate shareholders. Corporations do hold onto income so that shareholders do not have to pay income tax. The Republic has survived.


7. Is a stock dividend an increment to taxpayer’s store of rights of consumption? We tax all income once. When (and how) is a stock dividend taxed?


8. Income is taxed only once. “Basis” is money that will not again be subject to income tax, usually because it has already been subject to tax. Thus, basis is the means by which we keep score with the government. Mrs. Macomber owned 2200 shares of Standard Oil. Let’s say that she paid $220,000 for these shares, i.e., $100/share. After receiving the stock dividend, she owned 3300 shares.


• What should be her basis in both the original 2200 shares and the 1100 dividend shares?


• Suppose Justice Brandeis’s view had prevailed. What should be her basis in the original 2200 shares and in the 1100 dividend shares?


• Justice Brandeis acknowledged that he would tax corporate shareholders in the same manner as partners in a partnership are taxed.


• How do you think partners are taxed on undistributed partnership profits?


• How should that change a partner’s basis in his/her partnership interest?


• What should happen to the partner’s basis in his/her partnership interest if s/he later withdraws cash or property from the partnership?


Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955)



Mr. Chief Justice WARREN delivered the opinion of the Court.


This litigation involves two cases with independent factual backgrounds yet presenting the identical issue. … The common question is whether money received as exemplary damages for fraud or as the punitive two-thirds portion of a treble-damage antitrust recovery must be reported by a taxpayer as gross income under [§ 61] of the Internal Revenue Code. In a single opinion, 211 F.2d 928, the Court of Appeals [for the Third Circuit] affirmed the Tax Court’s separate rulings in favor of the taxpayers. [citation omitted] Because of the frequent recurrence of the question and differing interpretations by the lower courts of this Court’s decisions bearing upon the problem, we granted the Commissioner of the Internal Revenue’s ensuing petition for certiorari. [citation omitted]


The facts of the cases were largely stipulated and are not in dispute. So far as pertinent they are as follows:


Commissioner v. Glenshaw Glass Co. – The Glenshaw Glass Company, a Pennsylvania corporation, manufactures glass bottles and containers. It was engaged in protracted litigation with the Hartford-Empire Company, which manufactures machinery of a character used by Glenshaw. Among the claims advanced by Glenshaw were demands for exemplary damages for fraud and treble damages for injury to its business by reason of Hartford’s violation of the federal antitrust laws. In December, 1947, the parties concluded a settlement of all pending litigation, by which Hartford paid Glenshaw approximately $800,000. Through a method of allocation which was approved by the Tax Court, [citation omitted], and which is no longer in issue, it was ultimately determined that, of the total settlement, $324,529.94 represented payment of punitive damages for fraud and antitrust violations. Glenshaw did not report this portion of the settlement as income for the tax year involved. The Commissioner determined a deficiency claiming as taxable the entire sum less only deductible legal fees. …


Commissioner v. William Goldman Theatres, Inc. – William Goldman Theatres, Inc., a Delaware corporation operating motion picture houses in Pennsylvania, sued Loew’s, Inc., alleging a violation of the federal antitrust laws and seeking treble damages. … It was found that Goldman has suffered a loss of profits equal to $125,000 and was entitled to treble damages in the sum of $375,000. … Goldman reported only $125,000 of the recovery as gross income and claimed that the $250,000 balance constituted punitive damages and as such was not taxable. …


It is conceded by the respondents that there is no constitutional barrier to the imposition of a tax on punitive damages. Our question is one of statutory construction: are these payments comprehended by § [61](a)?


The sweeping scope of the controverted statute is readily apparent: …


This Court has frequently stated that this language was used by Congress to exert in this field ‘the full measure of its taxing power.’ [citations omitted] Respondents contend that punitive damages, characterized as ‘windfalls’ flowing from the culpable conduct of third parties, are not within the scope of the section. But Congress applied no limitations as to the source of taxable receipts, nor restrictive labels as to their nature. And the Court has given a liberal construction to this broad phraseology in recognition of the intention of Congress to tax all gains except those specifically exempted. [citations omitted] … [Our] decisions demonstrate that we cannot but ascribe content to the catchall provision of [§ 61(a)], ‘gains or profits and income derived from any source whatever.’ The importance of that phrase has been too frequently recognized since its first appearance in the Revenue Act of 1913 to say now that it adds nothing to the meaning of ‘gross income.’


Nor can we accept respondents’ contention that a narrower reading of [§ 61(a)] is required by the Court’s characterization of income in Eisner v. Macomber, 252 U.S. 189, 207, as “the gain derived from capital, from labor, or from both combined.”  … In that context – distinguishing gain from capital – the definition served a useful purpose. But it was not meant to provide a touchstone to all future gross income questions. [citations omitted]


Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients. Respondents concede, as they must, that the recoveries are taxable to the extent they compensate for damages actually incurred. It would be an anomaly that could not be justified in the absence of clear congressional intent to say that a recovery for actual damages is taxable but not the additional amount extracted as punishment for the same conduct which caused the injury. And we find no such evidence of intent to exempt these payments.






Mr. Justice DOUGLAS dissents. …


Notes and Questions:


1. Taxpayers acknowledged that Congress could constitutionally impose a tax on punitive damages. Interestingly, the Supreme Court has indeed observed many times that Congress exercised all of the power granted it by the Sixteenth Amendment. How much room does this really leave for a taxpayer to argue that Congress could tax windfalls but had not?


2. Memorize the elements of “gross income” stated in the first sentence of the last paragraph of the case. You’ll have to do this eventually, so save some time and do it now.


3. SHS holds that income includes all rights exercised in consumption plus changes in a taxpayer’s wealth. Does the phrase “accessions to wealth” encompass more or less than that?


4. Is the receipt of any accession to wealth, e.g., receiving exemplary damages, what most people think of as “income?” If not, what objectives does the Tax Code implicitly pursue by including all accessions to wealth in a taxpayer’s taxable income?


5. The following case provides a good primer (review) of Congress’s constitutional power to tax, a matter of considerable importance in today’s controversies concerning the financing of health care.


6. Read § 104(a)(2), including the carryout paragraph at the end of § 104(a).


Murphy v. Internal Revenue Service, 493 F.3d 170 (CADC 2007), cert. denied, 553 U.S. 1004 (2008)



On Rehearing


GINSBURG, Chief Judge:




I. Background


[After successfully complaining to the Department of Labor that her employer had blacklisted her in violation of various whistle-blower statutes, the Secretary of Labor ordered Marrita Murphy’s former employer to remove any adverse references about Murphy from the files of the Office of Personnel Management and remanded the case to determine compensatory damages. On remand, a psychologist testified that Murphy suffered both “somatic” and “emotional” injuries along with other “physical manifestations of stress, i.e., anxiety attacks, shortness of breath and dizziness. Also, Murphy’s medical records revealed she suffered from bruxism (teeth grinding), a condition often associated with stress that can cause permanent tooth damage. The Administrative Law Judge (ALJ) recommended $70,000 in compensatory damages: $45,000 for past and future emotional distress, and $25,000 for damage to Murphy’s vocational reputation. The Department of Labor Administrative Review Board (Board) affirmed the ALJ’s recommendation. Murphy included the $70,000 in her gross income, but later filed an amended return claiming that she was entitled to a refund because I.R.C. § 104(a)(2) excluded the $70,000 from her gross income. Murphy provided medical records documenting her physical injury and physical sickness. The IRS concluded that Murphy failed to prove that the compensation damages were attributable to “physical injury” or “physical sickness” and that I.R.C. § 104(a)(2) applied to her case. Hence, it rejected her claim for a refund. Murphy sued the IRS and the United States in federal district court.


Murphy argued: (1) I.R.C. § 104(a)(2) excluded the compensatory damages from her gross income because the award was for “physical personal injuries;” (2) taxing her award is unconstitutional because her damages were not “income” within the meaning of the Sixteenth Amendment. The district court rejected all of Murphy’s claims, and granted summary judgment for the IRS and the Government. Murphy appealed. On appeal, the court, 460 F.3d 79 (CADC 2006), reversed the district court’s decision, concluding that I.R.C. § 104(a)(2) did not exclude Murphy’s award from her gross income, but that her award was not “income” within the Sixteenth Amendment. The Government petitioned for a rehearing and argued that even if Murphy’s award was not “income” within the Sixteenth Amendment, there was no “constitutional impediment” to taxing Murphy’s award because a tax on such an award is not a direct tax and the tax is imposed uniformly. On rehearing, the court held that Murphy could not sue the IRS but could sue the United States.]


… In the present opinion, we affirm the judgment of the district court based upon the newly argued ground that Murphy’s award, even if it is not income within the meaning of the Sixteenth Amendment, is within the reach of the congressional power to tax under Article I, Section 8 of the Constitution.


II. Analysis




B. Section 104(a)(2) of the IRC


Section 104(a) (“Compensation for injuries or sickness”) provides that “gross income [under § 61 of the IRC] does not include the amount of any damages (other than punitive damages) received … on account of personal physical injuries or physical sickness.” 26 U.S.C. § 104(a)(2). Since 1996 it has further provided that, for purposes of this exclusion, “emotional distress shall not be treated as a physical injury or physical sickness.” Id. § 104(a). The version of § 104(a)(2) in effect prior to 1996 had excluded from gross income monies received in compensation for “personal injuries or sickness,” which included both physical and nonphysical injuries such as emotional distress. Id. § 104(a)(2) (1995); [citation omitted]. …




Murphy … contends that neither § 104 of the IRC nor the regulation issued thereunder “limits the physical disability exclusion to a physical stimulus.” In fact, as Murphy points out, the applicable regulation, which provides that § 104(a)(2) “excludes from gross income the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness,” 26 C.F.R. § 1.104-1(c), does not distinguish between physical injuries stemming from physical stimuli and those arising from emotional trauma …


For its part, the Government argues Murphy’s focus upon the word “physical” in § 104(a)(2) is misplaced; more important is the phrase “on account of.” In O’Gilvie v. United States, 519 U.S. 79 (1996), the Supreme Court read that phrase to require a “strong[ ] causal connection,” thereby making § 104(a)(2) “applicable only to those personal injury lawsuit damages that were awarded by reason of, or because of, the personal injuries.” The Court specifically rejected a “but-for” formulation in favor of a “stronger causal connection.” The Government therefore concludes Murphy must demonstrate she was awarded damages “because of” her physical injuries, which the Government claims she has failed to do.


Indeed, as the Government points out, the ALJ expressly recommended, and the Board expressly awarded, compensatory damages “because of” Murphy’s nonphysical injuries. … The Government therefore argues “there was no direct causal link between the damages award at issue and [Murphy’s] bruxism.”




Although the pre-1996 version of § 104(a)(2) was at issue in O’Gilvie, the Court’s analysis of the phrase “on account of,” which phrase was unchanged by the 1996 Amendments, remains controlling here. Murphy no doubt suffered from certain physical manifestations of emotional distress, but the record clearly indicates the Board awarded her compensation only “for mental pain and anguish” and “for injury to professional reputation.” … [W]e conclude Murphy’s damages were not “awarded by reason of, or because of, … [physical] personal injuries,” O’Gilvie, 519 U.S. at 83. Therefore, § 104(a)(2) does not permit Murphy to exclude her award from gross income.31



C. Section 61 of the IRC


Murphy and the Government agree that for Murphy’s award to be taxable, it must be part of her “gross income” as defined by § 61(a) …, which states in relevant part: “gross income means all income from whatever source derived.” The Supreme Court has interpreted the section broadly to extend to “all economic gains not otherwise exempted.” Comm’r v. Banks, 543 U.S. 426, 433 (2005); see also, e.g., [citation omitted]; Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 430 (“the Court has given a liberal construction to [“gross income”] in recognition of the intention of Congress to tax all gains except those specifically exempted”). “Gross income” in § 61(a) is at least as broad as the meaning of “incomes” in the Sixteenth Amendment. . See Glenshaw Glass, 348 U.S. at 429, 432 n. 11 (quoting H.R. Rep. No. 83-1337, at A18 (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4155); [citation omitted].


Murphy argues her award is not a gain or an accession to wealth and therefore not part of gross income. Noting the Supreme Court has long recognized “the principle that a restoration of capital [i]s not income; hence it [falls] outside the definition of ‘income’ upon which the law impose[s] a tax,” O’Gilvie, 519 U.S. at 84; [citations omitted], Murphy contends a damage award for personal injuries – including nonphysical injuries – should be viewed as a return of a particular form of capital – “human capital,” as it were. See Gary S. Becker, Human Capital (1st ed.1964); Gary S. Becker, The Economic Way of Looking at Life, Nobel Lecture (Dec. 9, 1992), in Nobel Lectures in Economic Sciences 1991-1995, at 43-45 (Torsten Persson ed., 1997). …


… Murphy cites various administrative rulings issued shortly after passage of the Sixteenth Amendment that concluded recoveries from personal injuries were not income, such as this 1918 Opinion of the Attorney General:


Without affirming that the human body is in a technical sense the “capital” invested in an accident policy, in a broad, natural sense the proceeds of the policy do but substitute, so far as they go, capital which is the source of future periodical income. They merely take the place of capital in human ability which was destroyed by the accident. They are therefore “capital” as distinguished from “income” receipts.


31 Op. Att’y Gen. 304, 308; see T.D. 2747, 20 Treas. Dec. Int. Rev. 457 (1918); Sol. Op. 132, I-1 C.B. 92, 93-94 (1922) (“[M]oney received … on account of … defamation of personal character … does not constitute income within the meaning of the sixteenth amendment and the statutes enacted thereunder”). …


Finally, Murphy argues her interpretation of § 61 is reflected in the common law of tort and the provisions in various environmental statutes and Title VII of the Civil Rights Act of 1964, all of which provide for “make whole” relief. See, e.g., 42 U.S.C. § 1981a; 15 U.S.C. § 2622. If a recovery of damages designed to “make whole” the plaintiff is taxable, she reasons, then one who receives the award has not been made whole after tax. Section 61 should not be read to create a conflict between the tax code and the “make whole” purpose of the various statutes.




Determining gain or loss on disposition of property: Section 1001 establishes a formula for determining gain or loss on the sale or other disposition of property. To determine gain, subtract adjusted basis from the amount realized. § 1001(a). We abbreviate this as AR − AB. To determine loss, subtract amount realized from adjusted basis. § 1001(a). Section 1001 does not impose any tax or determine any income; it simply provides a means of measuring gain or loss. Section 1012 defines “basis” to be the cost of property. Section 1011(a) defines “adjusted basis” to be “basis” as “adjusted.” Section 1016 names occasions for adjusting basis.





The Government disputes Murphy’s interpretation on all fronts. First, noting “the definition [of gross income in the IRC] extends broadly to all economic gains,” Banks, 543 U.S. at 433, the Government asserts Murphy “undeniably had economic gain because she was better off financially after receiving the damages award than she was prior to receiving it.” Second, the Government argues that the case law Murphy cites does not support the proposition that the Congress lacks the power to tax as income recoveries for personal injuries. In its view, to the extent the Supreme Court has addressed at all the taxability of compensatory damages, see, e.g., O’Gilvie, 519 U.S. at 86; Glenshaw Glass, 348 U.S. at 432 n. 8, it was merely articulating the Congress’s rationale at the time for not taxing such damages, not the Court’s own view whether such damages could constitutionally be taxed.


Third, the Government challenges the relevance of the administrative rulings Murphy cites from around the time the Sixteenth Amendment was ratified; Treasury decisions dating from even closer to the time of ratification treated damages received on account of personal injury as income. See T.D. 2135, 17 Treas. Dec. Int. Rev. 39, 42 (1915); T.D. 2690, Reg. No. 33 (Rev.), art. 4, 20 Treas. Dec. Int. Rev. 126, 130 (1918). Furthermore, administrative rulings from the time suggest that, even if recoveries for physical personal injuries were not considered part of income, recoveries for nonphysical personal injuries were. See Sol. Mem. 957, 1 C.B. 65 (1919) (damages for libel subject to income tax); Sol. Mem. 1384, 2 C.B. 71 (1920) (recovery of damages from alienation of wife’s affections not regarded as return of capital, hence taxable). Although the Treasury changed its position in 1922, see Sol. Op. 132, I-1 C.B. at 93-94, it did so only after the Supreme Court’s decision in Eisner v. Macomber, 252 U.S. 189 (1920), which the Court later viewed as having established a definition of income that “served a useful purpose [but] was not meant to provide a touchstone to all future gross income questions.” Glenshaw Glass, 348 U.S. at 430-31. As for Murphy’s contention that reading § 61 to include her damages would be in tension with the common law and various statutes providing for “make whole” relief, the Government denies there is any tension and suggests Murphy is trying to turn a disagreement over tax policy into a constitutional issue.


Finally, the Government argues that even if the concept of human capital is built into § 61, Murphy’s award is nonetheless taxable because Murphy has no tax basis in her human capital. Under the IRC, a taxpayer’s gain upon the disposition of property is the difference between the “amount realized” from the disposition and his basis in the property, 26 U.S.C. § 1001, defined as “the cost of such property,” id. § 1012, adjusted “for expenditures, receipts, losses, or other items, properly chargeable to [a] capital account,” id. § 1016(a)(1). The Government asserts, “The Code does not allow individuals to claim a basis in their human capital;” accordingly, Murphy’s gain is the full value of the award. See Roemer v. Comm’r, 716 F.2d 693, 696 n. 2 (9th Cir.1983) (“Since there is no tax basis in a person’s health and other personal interests, money received as compensation for an injury to those interests might be considered a realized accession to wealth”) (dictum).


Although Murphy and the Government focus primarily upon whether Murphy’s award falls within the definition of income first used in Glenshaw Glass , coming within that definition is not the only way in which § 61(a) could be held to encompass her award. Principles of statutory interpretation could show § 61(a) includes Murphy’s award in her gross income regardless whether it was an “accession to wealth,” as Glenshaw Glass requires. For example, if § 61(a) were amended specifically to include in gross income “$100,000 in addition to all other gross income,” then that additional sum would be a part of gross income under § 61 even though no actual gain was associated with it. In other words, although the “Congress cannot make a thing income which is not so in fact,” Burk-Waggoner Oil Ass’n v. Hopkins, 269 U.S. 110, 114 (1925), it can label a thing income and tax it, so long as it acts within its constitutional authority, which includes not only the Sixteenth Amendment but also Article I, Sections 8 and 9. See Penn Mut. Indem. Co. v. Comm’r, 277 F.2d 16, 20 (3d Cir.1960) (“Congress has the power to impose taxes generally, and if the particular imposition does not run afoul of any constitutional restrictions then the tax is lawful, call it what you will”) (footnote omitted). Accordingly, rather than ask whether Murphy’s award was an accession to her wealth, we go to the heart of the matter, which is whether her award is properly included within the definition of gross income in § 61(a), to wit, “all income from whatever source derived.”


Looking at § 61(a) by itself, one sees no indication that it covers Murphy’s award unless the award is “income” as defined by Glenshaw Glass and later cases. Damages received for emotional distress are not listed among the examples of income in § 61 and, as Murphy points out, an ambiguity in the meaning of a revenue-raising statute should be resolved in favor of the taxpayer. See, e.g., Hassett v. Welch, 303 U.S. 303, 314 (1938); Gould v. Gould, 245 U.S. 151, 153 (1917); [citations omitted]. A statute is to be read as a whole, however [citation omitted], and reading § 61 in combination with § 104(a)(2) of the Internal Revenue Code presents a very different picture – a picture so clear that we have no occasion to apply the canon favoring the interpretation of ambiguous revenue-raising statutes in favor of the taxpayer.


… [I]n 1996 the Congress amended § 104(a) to narrow the exclusion to amounts received on account of “personal physical injuries or physical sickness” from “personal injuries or sickness,” and explicitly to provide that “emotional distress shall not be treated as a physical injury or physical sickness,” thus making clear that an award received on account of emotional distress is not excluded from gross income under § 104(a)(2). Small Business Job Protection Act of 1996, Pub. L. 104-188, § 1605, 110 Stat. 1755, 1838. As this amendment, which narrows the exclusion, would have no effect whatsoever if such damages were not included within the ambit of § 61, and as we must presume that “[w]hen Congress acts to amend a statute, … it intends its amendment to have real and substantial effect,” Stone v. INS, 514 U.S. 386, 397 (1995), the 1996 amendment of § 104(a) strongly suggests § 61 should be read to include an award for damages from nonphysical harms. . …




… For the 1996 amendment of § 104(a) to “make sense,” gross income in § 61(a) must, and we therefore hold it does, include an award for nonphysical damages such as Murphy received, regardless whether the award is an accession to wealth. [citation omitted].


D. The Congress’s Power to Tax


The taxing power of the Congress is established by Article I, Section 8 of the Constitution: “The Congress shall have power to lay and collect taxes, duties, imposts and excises.” There are two limitations on this power. First, as the same section goes on to provide, “all duties, imposts and excises shall be uniform throughout the United States.” Second, as provided in Section 9 of that same Article, “No capitation, or other direct, tax shall be laid, unless in proportion to the census or enumeration herein before directed to be taken.” See also U.S. Const. art. I, § 2, cl. 3 (“direct taxes shall be apportioned among the several states which may be included within this union, according to their respective numbers”).32 We now consider whether the tax laid upon Murphy’s award violates either of these two constraints.



1. A Direct Tax?


Over the years, courts have considered numerous claims that one or another nonapportioned tax is a direct tax and therefore unconstitutional. Although these cases have not definitively marked the boundary between taxes that must be apportioned and taxes that need not be, see Bromley v. McCaughn, 280 U.S. 124, 136 (1929); Spreckels Sugar Ref. Co. v. McClain, 192 U.S. 397, 413 (1904) (dividing line between “taxes that are direct and those which are to be regarded simply as excises” is “often very difficult to be expressed in words”), some characteristics of each may be discerned.


Only three taxes are definitely known to be direct: (1) a capitation, U.S. Const. art. I, § 9, (2) a tax upon real property, and (3) a tax upon personal property. See Fernandez v. Wiener, 326 U.S. 340, 352 (1945) (“Congress may tax real estate or chattels if the tax is apportioned”); Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 601, 637 (1895) (Pollock II).33 Such direct taxes are laid upon one’s “general ownership of property,” Bromley, 280 U.S. at 136; see also Flint v. Stone Tracy Co., 220 U.S. 107, 149 (1911), as contrasted with excise taxes laid “upon a particular use or enjoyment of property or the shifting from one to another of any power or privilege incidental to the ownership or enjoyment of property.” Fernandez, 326 U.S. at 352; see also Thomas v. United States, 192 U.S. 363, 370 (1904) (excises cover “duties imposed on importation, consumption, manufacture and sale of certain commodities, privileges, particular business transactions, vocations, occupations and the like”). More specifically, excise taxes include, in addition to taxes upon consumable items [citation omitted], taxes upon the sale of grain on an exchange, Nicol v. Ames, 173 U.S. 509, 519 (1899), the sale of corporate stock, Thomas, 192 U.S. at 371, doing business in corporate form, Flint, 220 U.S. at 151, gross receipts from the “business of refining sugar,” Spreckels, 192 U.S. at 411, the transfer of property at death, Knowlton v. Moore, 178 U.S. 41, 81-82 (1900), gifts, Bromley, 280 U.S. at 138, and income from employment, see Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429, 579 (1895) (Pollock I) (citing Springer v. United States, 102 U.S. 586 (1881)).



Murphy and the amici supporting her argue the dividing line between direct and indirect taxes is based upon the ultimate incidence of the tax; if the tax cannot be shifted to someone else, as a capitation cannot, then it is a direct tax; but if the burden can be passed along through a higher price, as a sales tax upon a consumable good can be, then the tax is indirect. This, she argues, was the distinction drawn when the Constitution was ratified. See Albert Gallatin, A Sketch of the Finances of the United States (1796), reprinted in 3 The Writings of Albert Gallatin 74-75 (Henry Adams ed., Philadelphia, J.P. Lippincott & Co. 1879) (“The most generally received opinion … is, that by direct taxes … those are meant which are raised on the capital or revenue of the people; by indirect, such as are raised on their expense”); The Federalist No. 36, at 225 (Alexander Hamilton) (Jacob E. Cooke ed., 1961) (“internal taxes[ ] may be subdivided into those of the direct and those of the indirect kind … by which must be understood duties and excises on articles of consumption”). But see Gallatin, supra, at 74 (“[Direct tax] is used, by different writers, and even by the same writers, in different parts of their writings, in a variety of senses, according to that view of the subject they were taking”); Edwin R.A. Seligman, The Income Tax 540 (photo. reprint 1970) (2d ed.1914) (“there are almost as many classifications of direct and indirect taxes are there are authors”). Moreover, the amici argue, this understanding of the distinction explains the different restrictions imposed respectively upon the power of the Congress to tax directly (apportionment) and via excise (uniformity). Duties, imposts, and excise taxes, which were expected to constitute the bulk of the new federal government’s revenue, see Erik M. Jensen, The Apportionment of “Direct Taxes”: Are Consumption Taxes Constitutional?, 97 Colum. L. Rev. 2334, 2382 (1997), have a built-in safeguard against oppressively high rates: Higher taxes result in higher prices and therefore fewer sales and ultimately lower tax revenues. See The Federalist No. 21, supra, at 134-35 (Alexander Hamilton). Taxes that cannot be shifted, in contrast, lack this self-regulating feature, and were therefore constrained by the more stringent requirement of apportionment. See id. at 135 (“In a branch of taxation where no limits to the discretion of the government are to be found in the nature of things, the establishment of a fixed rule … may be attended with fewer inconveniences than to leave that discretion altogether at large”); see also Jensen, supra, at 2382-84.


Finally, the amici contend their understanding of a direct tax was confirmed in Pollock II, where the Supreme Court noted that “the words ‘duties, imposts, and excises’ are put in antithesis to direct taxes,” 158 U.S. at 622, for which it cited The Federalist No. 36 (Hamilton). Pollock II, 158 U.S. at 624-25. As it is clear that Murphy cannot shift her tax burden to anyone else, per Murphy and the amici, it must be a direct tax.


The Government, unsurprisingly, backs a different approach; by its lights, only “taxes that are capable of apportionment in the first instance, specifically, capitation taxes and taxes on land,” are direct taxes. The Government maintains that this is how the term was generally understood at the time. See Calvin H. Johnson, Fixing the Constitutional Absurdity of the Apportionment of Direct Tax, 21 Const. Comm. 295, 314 (2004). Moreover, it suggests, this understanding is more in line with the underlying purpose of the tax and the apportionment clauses, which were drafted in the intense light of experience under the Articles of Confederation.


The Articles did not grant the Continental Congress the power to raise revenue directly; it could only requisition funds from the States. See Articles of Confederation art. VIII (1781); Bruce Ackerman, Taxation and the Constitution, 99 Colum. L. Rev. 1, 6-7 (1999). This led to problems when the States, as they often did, refused to remit funds. See Calvin H. Johnson, The Constitutional Meaning of “Apportionment of Direct Taxes,” 80 Tax Notes 591, 593-94 (1998). The Constitution redressed this problem by giving the new national government plenary taxing power. See Ackerman, supra, at 7. In the Government’s view, it therefore makes no sense to treat “direct taxes” as encompassing taxes for which apportionment is effectively impossible, because “the Framers could not have intended to give Congress plenary taxing power, on the one hand, and then so limit that power by requiring apportionment for a broad category of taxes, on the other.” This view is, according to the Government, buttressed by evidence that the purpose of the apportionment clauses was not in fact to constrain the power to tax, but rather to placate opponents of the compromise over representation of the slave states in the House, as embodied in the Three-fifths Clause.34 See Ackerman, supra, at 10-11. See generally Seligman, supra, at 548-55. As the Government interprets the historical record, the apportionment limitation was “more symbolic than anything else: it appeased the anti-slavery sentiment of the North and offered a practical advantage to the South as long as the scope of direct taxes was limited.” See Ackerman, supra, at 10. But see Erik M. Jensen, Taxation and the Constitution: How to Read the Direct Tax Clauses, 15 J.L. & Pol. 687, 704 (1999) (“One of the reasons [the direct tax restriction] worked as a compromise was that it had teeth – it made direct taxes difficult to impose – and it had teeth however slaves were counted”).



The Government’s view of the clauses is further supported by the near contemporaneous decision of the Supreme Court in Hylton v. United States, 3 U.S. (3 Dall.) 171 (1796), holding that a national tax upon carriages was not a direct tax, and thus not subject to apportionment. Justices Chase and Iredell opined that a “direct tax” was one that, unlike the carriage tax, as a practical matter could be apportioned among the States, id. at 174 (Chase, J.); id. at 181 (Iredell, J.), while Justice Paterson, noting the connection between apportionment and slavery, condemned apportionment as “radically wrong” and “not to be extended by construction,” id. at 177-78. . As for Murphy’s reliance upon Pollock II, the Government contends that although it has never been overruled, “every aspect of its reasoning has been eroded,” see, e.g., Stanton v. Baltic Mining Co., 240 U.S. 103, 112-13 (1916), and notes that in Pollock II itself the Court acknowledged that “taxation on business, privileges, or employments has assumed the guise of an excise tax,” 158 U.S. at 635. Pollock II, in the Government’s view, is therefore too weak a reed to support Murphy’s broad definition of “direct tax” and certainly does not make “a tax on the conversion of human capital into money … problematic.”


Murphy replies that the Government’s historical analysis does not respond to the contemporaneous sources she and the amici identified showing that taxes imposed upon individuals are direct taxes. As for Hylton, Murphy argues nothing in that decision precludes her position; the Justices viewed the carriage tax there at issue as a tax upon an expense, see 3 U.S. (3 Dall.) at 175 (Chase, J.); see also id. at 180-81 (Paterson, J.), which she agrees is not a direct tax. See Pollock II, 158 U.S. at 626-27. To the extent Hylton is inconsistent with her position, however, Murphy contends her references to the Federalist are more authoritative evidence of the Framers’ understanding of the term.


Murphy makes no attempt to reconcile her definition with the long line of cases identifying various taxes as excise taxes, although several of them seem to refute her position directly. In particular, we do not see how a known excise, such as the estate tax, see, e.g., New York Trust Co. v. Eisner, 256 U.S. 345, 349 (1921); Knowlton, 178 U.S. at 81-83, or a tax upon income from employment, see Pollock II, 158 U.S. at 635; Pollock I, 157 U.S. at 579; cf. Steward Mach. Co. v. Davis, 301 U.S. 548, 580-81 (1937) (tax upon employers based upon wages paid to employees is an excise), can be shifted to another person, absent which they seem to be in irreconcilable conflict with her position that a tax that cannot be shifted to someone else is a direct tax. Though it could be argued that the incidence of an estate tax is inevitably shifted to the beneficiaries, we see at work none of the restraint upon excessive taxation that Murphy claims such shifting is supposed to provide; the tax is triggered by an event, death, that cannot be shifted or avoided. In any event, Knowlton addressed the argument that Pollock I and II made ability to shift the hallmark of a direct tax, and rejected it. 178 U.S. at 81-82. Regardless what the original understanding may have been, therefore, we are bound to follow the Supreme Court, which has strongly intimated that Murphy’s position is not the law.


That said, neither need we adopt the Government’s position that direct taxes are only those capable of satisfying the constraint of apportionment. In the abstract, such a constraint is no constraint at all; virtually any tax may be apportioned by establishing different rates in different states. See Pollock II, 158 U.S. at 632-33. If the Government’s position is instead that by “capable of apportionment” it means “capable of apportionment in a manner that does not unfairly tax some individuals more than others,” then it is difficult to see how a land tax, which is widely understood to be a direct tax, could be apportioned by population without similarly imposing significantly non-uniform rates. See Hylton, 3 U.S. (3 Dall.) at 178-79 (Paterson, J.); Johnson, Constitutional Absurdity, supra, at 328. But see, e.g., Hylton, 3 U.S. (3 Dall.) at 183 (Iredell, J.) (contending land tax is capable of apportionment).


We find it more appropriate to analyze this case based upon the precedents and therefore to ask whether the tax laid upon Murphy’s award is more akin, on the one hand, to a capitation or a tax upon one’s ownership of property, or, on the other hand, more like a tax upon a use of property, a privilege, an activity, or a transaction, see Thomas, 192 U.S. at 370. Even if we assume one’s human capital should be treated as personal property, it does not appear that this tax is upon ownership; rather, as the Government points out, Murphy is taxed only after she receives a compensatory award, which makes the tax seem to be laid upon a transaction. See Tyler v. United States, 281 U.S. 497, 502 (1930) (“A tax laid upon the happening of an event, as distinguished from its tangible fruits, is an indirect tax which Congress, in respect of some events … undoubtedly may impose”); Simmons v. United States, 308 F.2d 160, 166 (4th Cir.1962) (tax upon receipt of money is not a direct tax); [citation omitted]. Murphy’s situation seems akin to an involuntary conversion of assets; she was forced to surrender some part of her mental health and reputation in return for monetary damages. Cf. 26 U.S.C. § 1033 (property involuntarily converted into money is taxed to extent of gain recognized).


At oral argument Murphy resisted this formulation on the ground that the receipt of an award in lieu of lost mental health or reputation is not a transaction. This view is tenable, however, only if one decouples Murphy’s injury (emotional distress and lost reputation) from her monetary award, but that is not beneficial to Murphy’s cause, for then Murphy has nothing to offset the obvious accession to her wealth, which is taxable as income. Murphy also suggested at oral argument that there was no transaction because she did not profit. Whether she profited is irrelevant, however, to whether a tax upon an award of damages is a direct tax requiring apportionment; profit is relevant only to whether, if it is a direct tax, it nevertheless need not be apportioned because the object of the tax is income within the meaning of the Sixteenth Amendment. Cf. Spreckels, 192 U.S. at 412-13 (tax upon gross receipts associated with business of refining sugar not a direct tax); Penn Mut., 277 F.2d at 20 (tax upon gross receipts deemed valid indirect tax despite taxpayer’s net loss).


So we return to the question: Is a tax upon this particular kind of transaction equivalent to a tax upon a person or his property? [citation omitted]. Murphy did not receive her damages pursuant to a business activity [citations omitted], and we therefore do not view this tax as an excise under that theory. See Stratton’s Independence, Ltd. v. Howbert, 231 U.S. 399, 414-15 (1913) (“The sale outright of a mining property might be fairly described as a mere conversion of the capital from land into money”). On the other hand, as noted above, the Supreme Court several times has held a tax not related to business activity is nonetheless an excise. And the tax at issue here is similar to those.


Bromley, in which a gift tax was deemed an excise, is particularly instructive: The Court noted it was “a tax laid only upon the exercise of a single one of those powers incident to ownership,” 280 U.S. at 136, which distinguished it from “a tax which falls upon the owner merely because he is owner, regardless of the use or disposition made of his property,” id. at 137. A gift is the functional equivalent of a below-market sale; it therefore stands to reason that if, as Bromley holds, a gift tax, or a tax upon a below-market sale, is a tax laid not upon ownership but upon the exercise of a power “incident to ownership,” then a tax upon the sale of property at fair market value is similarly laid upon an incidental power and not upon ownership, and hence is an excise. Therefore, even if we were to accept Murphy’s argument that the human capital concept is reflected in the Sixteenth Amendment, a tax upon the involuntary conversion of that capital would still be an excise and not subject to the requirement of apportionment. But see Nicol, 173 U.S. at 521 (indicating pre-Bromley that tax upon “every sale made in any place … is really and practically upon property”).


In any event, even if a tax upon the sale of property is a direct tax upon the property itself, we do not believe Murphy’s situation involves a tax “upon the sale itself, considered separate and apart from the place and the circumstances of the sale.” Id. at 520. Instead, as in Nicol, this tax is more akin to “a duty upon the facilities made use of and actually employed in the transaction.” Id. at 519. To be sure, the facility used in Nicol was a commodities exchange whereas the facility used by Murphy was the legal system, but that hardly seems a significant distinction. The tax may be laid upon the proceeds received when one vindicates a statutory right, but the right is nonetheless a “creature of law,” which Knowlton identifies as a “privilege” taxable by excise. 178 U.S. at 55 (right to take property by inheritance is granted by law and therefore taxable as upon a privilege);35 cf. Steward, 301 U.S. at 580-81 (“[N]atural rights, so called, are as much subject to taxation as rights of less importance. An excise is not limited to vocations or activities that may be prohibited altogether…. It extends to vocations or activities pursued as of common right.”) (footnote omitted).



2. Uniformity


The Congress may not implement an excise tax that is not “uniform throughout the United States.” U.S. Const. art. I, § 8, cl. 1. A “tax is uniform when it operates with the same force and effect in every place where the subject of it is found.” United States v. Ptasynski, 462 U.S. 74, 82 (1983) (internal quotation marks omitted); see also Knowlton, 178 U.S. at 84-86, 106. The tax laid upon an award of damages for a nonphysical personal injury operates with “the same force and effect” throughout the United States and therefore satisfies the requirement of uniformity.


III. Conclusion


For the foregoing reasons, we conclude (1) Murphy’s compensatory award was not received on account of personal physical injuries, and therefore is not exempt from taxation pursuant to § 104(a)(2) of the IRC; (2) the award is part of her “gross income,” as defined by § 61 of the IRC; and (3) the tax upon the award is an excise and not a direct tax subject to the apportionment requirement of Article I, Section 9 of the Constitution. The tax is uniform throughout the United States and therefore passes constitutional muster. The judgment of the district court is accordingly




Exclusions from Gross Income: Section 104(a)(2), which the court quoted, provides for an exclusion from gross income. Obviously $70,000 is money that taxpayer could spend. If an exclusion had applied, taxpayer would not have to count it in her gross income even though she clearly received it.







Notes and Questions:


1. Notice in the first footnote of the case, the court acknowledged an inconsistency between a regulation and the Code. Obviously, the Code prevails. See ch. 1, § VII supra.


2. In the first paragraph of part IIC, the court states our second guiding principle of tax law: “There are exceptions to [the principle that we tax all of the income of a particular taxpayer once], but we usually must find those exceptions in the Code itself.”


3. What is supposed to determine the measure of compensatory damages in tort law? Exactly what is the “restoration of capital” argument that the Attorney General bought into in the early days of the income tax? See Clark v. Commissioner, infra.


• Why is this argument no longer persuasive?




Basis, Restoration of Capital, and MONEY: The income tax is all about money, i.e., U.S. dollars. Basis is how we keep score with the government. We keep score in terms of dollars – not in terms of emotional well-being or happiness. These latter concepts are real enough, but not capable of valuation in terms of money. While tort law may structure an after-the-fact exchange of money for emotional well-being, tax law does not recognize the non-monetary aspects of the exchange – except as § 104 otherwise provides.





4. What is a direct tax under the Constitution? What taxes do we know are direct taxes? What is the constitutional limitation upon Congress’s power to enact direct taxes?


• The Supreme Court’s most recent pronouncement on the subject came in National Federation of Independent Business v. Sebelius, 567 U.S. ___, 132 S. Ct. 2566 (2012):


A tax on going without health insurance does not fall within any recognized category of direct tax. It is not a capitation. … The whole point of the shared responsibility payment is that it is triggered by specific circumstances—earning a certain amount of income but not obtaining health insurance. The payment is also plainly not a tax on the ownership of land or personal property. The shared responsibility payment is thus not a direct tax that must be apportioned among the several States.


Id. at ___, 132 S. Ct. at 2599.


5. What is an indirect tax under the Constitution? What taxes do we know are indirect taxes? What is the constitutional limitation upon Congress’s power to enact indirect taxes?


6. The court provides a good review of the power of Congress to impose taxes aside from the income tax. The court acknowledged that a tax on tort damages for emotional distress might not be a tax on income in the constitutional sense (i.e., Sixteenth Amendment) of the word. How should this affect the fact that all items of gross income are added together and form the bases of other important elements of the income tax, e.g., AGI, tax brackets applicable to all income. Might a tax upon such damages therefore render the constitutionality of the income tax questionable with respect to taxpayers such as Marrita Murphy?


7. Do you think that taxpayer Murphy would place more value on her pre-event emotional tranquility and happiness or on her post-event emotional tranquility, happiness, and $70,000?


• Is it possible that we tax events that actually reduce a taxpayer’s overall wealth?


8. The court cited the case of Penn Mut. Indem. Co. v. Comm’r, 277 F.2d 16, 20 (CA3 1960) with this parenthetical: “Congress has the power to impose taxes generally, and if the particular imposition does not run afoul of any constitutional restrictions then the tax is lawful, call it what you will.” In National Federation of Independent Business v. Sebelius, 567 U.S. ___, 132 S. Ct. 2566 (2012), the Supreme Court “confirmed” a “functional approach” to whether an assessment is a tax. 567 U.S. at ___, 132 S. Ct. at 2594-96 (“shared responsibility payment” actually a “tax,” even though called a “penalty”).


• In Eisner v. Macomber, the Supreme Court said: “Congress cannot by any definition [of “income”] it may adopt conclude the matter, since it cannot by legislation alter the Constitution, from which alone it derives its power to legislate, and within whose limitations alone that power can be lawfully exercised.”


• Are these positions inconsistent?


• Does this imply that Congress can enact a tax – assuming that the legislative proposal originates in the House of Representatives – and later search for its constitutional underpinning?


II. The Constitutional and Statutory Definitions of “Gross Income:” Accessions to Wealth



A. Some Recurring Themes



Consider now the many forms that an “accession to wealth” can take. Section 61(a) of the Code provides a non-exclusive list of fifteen items. Obviously, “gross income” includes compensation for services. § 61(a)(1). We should not be especially surprised that “gross income” includes the other items on the list. However, the first sentence of § 61(a) does not limit “gross income” to the items on this list. This point has required courts to consider whether various benefits constituted an “accession to wealth.” The following cases, some of which pre-date Glenshaw Glass, present some examples.


Old Colony Trust Co. v. Commissioner, 279 U.S. 716 (1929)



MR. CHIEF JUSTICE TAFT delivered the opinion of the Court.




William M. Wood was president of the American Woolen Company during the years 1918, 1919, and 1920. In 1918 he received as salary and commissions from the company $978,725, which he included in his federal income tax return for 1918. In 1919, he received as salary and commissions from the company $548,132.87, which he included in his return for 1919.


August 3, 1916, the American Woolen Company had adopted the following resolution, which was in effect in 1919 and 1920:


“Voted: That this company pay any and all income taxes, state and Federal, that may hereafter become due and payable upon the salaries of all the officers of the company, including the president, William M. Wood[,] … to the end that said persons and officers shall receive their salaries or other compensation in full without deduction on account of income taxes, state or federal, which taxes are to be paid out of the treasury of this corporation.”




… [T]he American Woolen Company paid to the collector of internal revenue Mr. Wood’s federal income and surtaxes due to salary and commissions paid him by the company, as follows:


Taxes for 1918 paid in 1919 . . . . $681,169 88


Taxes for 1919 paid in 1920 . . . . $351,179 27


The decision of the Board of Tax Appeals here sought to be reviewed was that the income taxes of $681,169.88 and $351,179.27 paid by the American Woolen Company for Mr. Wood were additional income to him for the years 1919 and 1920.


The question certified by the circuit court of appeals for answer by this Court is:


“Did the payment by the employer of the income taxes assessable against the employee constitute additional taxable income to such employee?”




… Coming now to the merits of this case, we think the question presented is whether a taxpayer, having induced a third person to pay his income tax or having acquiesced in such payment as made in discharge of an obligation to him, may avoid the making of a return thereof and the payment of a corresponding tax. We think he may not do so. The payment of the tax by the employers was in consideration of the services rendered by the employee, and was again derived by the employee from his labor. The form of the payment is expressly declared to make no difference. Section 213, Revenue Act of 1918, c. 18, 40 Stat. 1065 [§ 61]. It is therefore immaterial that the taxes were directly paid over to the government. The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed. The certificate shows that the taxes were imposed upon the employee, that the taxes were actually paid by the employer, and that the employee entered upon his duties in the years in question under the express agreement that his income taxes would be paid by his employer. … The taxes were paid upon a valuable consideration – namely, the services rendered by the employee and as part of the compensation therefor. We think, therefore, that the payment constituted income to the employee.




Nor can it be argued that the payment of the tax … was a gift. The payment for services, even though entirely voluntary, was nevertheless compensation within the statute. …


It is next argued against the payment of this tax that, if these payments by the employer constitute income to the employee, the employee will be called upon to pay the tax imposed upon this additional income, and that the payment of the additional tax will create further income which will in turn be subject to tax, with the result that there would be a tax upon a tax. This, it is urged, is the result of the government’s theory, when carried to its logical conclusion, and results in an absurdity which Congress could not have contemplated.


In the first place, no attempt has been made by the Treasury to collect further taxes upon the theory that the payment of the additional taxes creates further income, and the question of a tax upon a tax was not before the circuit court of appeals, and has not been certified to this Court. We can settle questions of that sort when an attempt to impose a tax upon a tax is undertaken, but not now. [citations omitted]. It is not, therefore, necessary to answer the argument based upon an algebraic formula to reach the amount of taxes due. The question in this case is, “Did the payment by the employer of the income taxes assessable against the employee constitute additional taxable income to such employee?” The answer must be “Yes.”


Separate opinion of MR. JUSTICE McREYNOLDS [omitted].


Notes and Questions:


1. Taxpayers pay their federal income taxes from after-tax income. This was not always true. Act of Oct. 3, 1913, entitled “An act to reduce tariff duties and to provide revenue for the Government and for other purposes,” part IIB, granted a deduction for national taxes paid. After Congress repealed this deduction, the American Woolen Company began paying William Wood’s federal income taxes.


2. The Court seems to say both that taxpayer received additional compensation (taxable) and that taxpayer benefitted from third-party satisfaction of an obligation (also taxable).




A Little Algebra: Is the argument that the Commissioner creates a never-ending upward spiral of taxes upon taxes true?


• No.


• If taxpayer is to have $X remaining after payment of taxes and the tax rate is λ, then taxable income equal to $X/(1 - λ) will produce $X of after-tax income. Obviously, graduated tax rates would require some incremental computations.


• We call such a computation “grossing up.”





3. A taxpayer’s wealth increases when someone pays one of his/her obligations. Thus, when taxpayer’s employer pays taxpayer’s federal income taxes, taxpayer should include the amount of taxes in his/her gross income. The principal is applicable in other contexts as well.


• A key consideration is whether a third party makes a payment to satisfy an actual “obligation” of the taxpayer, or merely to “restore” to taxpayer “capital” rightfully belonging to him/her. See Clark infra.


Clark v. Commissioner, 40 B.T.A. 333 (1939)



Opinion. LEECH.


This is a proceeding to redetermine a deficiency in income tax for the calendar year 1934 in the amount of $10,618.87. The question presented is whether petitioner derived income by the payment to him of an amount of $19,941.10, by his tax counsel, to compensate him for a loss suffered on account of erroneous advice given him by the latter. The facts were stipulated and … so far as material, follow[]:


3. The petitioner during the calendar year 1932, and for a considerable period prior thereto, was married and living with his wife. He was required by the Revenue Act of 1932 to file a Federal Income Tax Return of his income for the year 1932. For such year petitioner and his wife could have filed a joint return or separate returns.


4. Prior to the time that the 1932 Federal Income Tax return or returns of petitioner and/or his wife were due to be filed, petitioner retained experienced counsel to prepare the necessary return or returns for him and/or his wife. Such tax counsel prepared a joint return for petitioner and his wife and advised petitioner to file it instead of two separate returns. In due course it was filed with the Collector of Internal Revenue for the First District of California. …




6. [Tax counsel had improperly deducted more than the allowable amount of capital losses.]


7. The error referred to in paragraph six above was called to the attention of the tax counsel who prepared the joint return of petitioner and his wife for the year 1932. Recomputations were then made which disclosed that if petitioner and his wife had filed separate returns for the year 1932 their combined tax liability would have been $19,941.10 less than that which was finally assessed against and paid by petitioner.


8. Thereafter, tax counsel admitted that if he had not erred in computing the tax liability shown on the joint return filed by the petitioner, he would have advised petitioner to file separate returns for himself and his wife, and accordingly tax counsel tendered to petitioner the sum of $19,941.10, which was the difference between what petitioner and his wife would have paid on their 1932 returns if separate returns had been filed and the amount which petitioner was actually required to pay on the joint return as filed. Petitioner accepted the $19,941.10.


9. In his final determination of petitioner’s 1934 tax liability, the respondent included the aforesaid $19,941.10 in income.


10. Petitioner’s books of account are kept on the cash receipts and disbursements basis and his tax returns are made on such basis under the community property laws of the State of California.


The theory on which the respondent included the above sum of $19,941.10 in petitioner’s gross income for 1934, is that this amount constituted taxes paid for petitioner by a third party and that, consequently, petitioner was in receipt of income to that extent. … Petitioner, on the contrary, contends that this payment constituted compensation for damages or loss caused by the error of tax counsel, and that he therefore realized no income from its receipt in 1934.


We agree with the petitioner. … Petitioner’s taxes were not paid for him by any person – as rental, compensation for services rendered, or otherwise. He paid his own taxes.


When the joint return was filed, petitioner became obligated to and did pay the taxes computed on that basis. [citation omitted] In paying that obligation, he sustained a loss which was caused by the negligence of his tax counsel. The $19,941.10 was paid to petitioner, not qua taxes [citation omitted], but as compensation to petitioner for his loss. The measure of that loss, and the compensation therefor, was the sum of money which petitioner became legally obligated to and did pay because of that negligence. The fact that such obligation was for taxes is of no moment here.




… And the fact that the payment of the compensation for such loss was voluntary, as here, does not change its exempt status. [citation omitted] It was, in fact, compensation for a loss which impaired petitioner’s capital.


Moreover, so long as petitioner neither could nor did take a deduction in a prior year of this loss in such a way as to offset income for the prior year, the amount received by him in the taxable year, by way of recompense, is not then includable in his gross income. Central Loan & Investment Co., 39 B.T.A. 981.


Decision will be entered for the petitioner.


Notes and Questions:


1. Does the Commissioner’s position follow from the Supreme Court’s holding in Old Colony Trust?




A return of capital is not gross income. After all, the capital that is returned has already been subject to income tax.





2. Is this holding consistent with SHS? What do you know from reading the case about what taxpayer’s after-tax wealth should have been? In fact, is that not what the court was referencing when it described the payment as “compensation for a loss which impaired [taxpayer’s] capital?


3. Why would it make a difference whether taxpayer previously deducted the amount restored to him?


Gotcher v. United States, 401 F.2d 118 (CA5 1968)



THORNBERRY, Circuit Judge.


In 1960, Mr. and Mrs. Gotcher took a twelve-day expense-paid trip to Germany to tour the Volkswagon facilities there. The trip cost $1372.30. His employer, Economy Motors, paid $348.73, and Volkswagon of Germany and Volkswagon of America shared the remaining $1023.53. Upon returning, Mr. Gotcher bought a twenty-five percent interest in Economy Motors, the Sherman, Texas Volkswagon dealership, that had been offered to him before he left. Today he is President of Economy Motors in Sherman and owns fifty percent of the dealership. Mr. and Mrs. Gotcher did not include any part of the $1372.30 in their 1960 income. The Commissioner determined that the taxpayers had realized income to the extent of the $1372.30 for the expense-paid trip and asserted a tax deficiency of $356.79, plus interest. Taxpayers paid the deficiency, plus $82.29 in interest, and thereafter timely filed suit for a refund. The district court, sitting without a jury, held that the cost of the trip was not income or, in the alternative, was income and deductible as an ordinary and necessary business expense. [citation omitted] We affirm the district court’s determination that the cost of the trip was not income to Mr. Gotcher ($686.15); however, Mrs. Gotcher’s expenses ($686.15) constituted income and were not deductible.


… The court below reasoned that the cost of the trip to the Gotchers was not income because an economic or financial benefit does not constitute income under § 61 unless it is conferred as compensation for services rendered. This conception of gross income is too restrictive since it is [well]-settled that § 61 should be broadly interpreted and that many items, including compensatory gains, constitute gross income.


Sections 101-123 specifically exclude certain items from gross income. Appellant argues that the cost of the trip should be included in income since it is not specifically excluded by §§ 101-123, reasoning that § 61 was drafted broadly to subject all economic gains to tax and any exclusions should be narrowly limited to the specific exclusions. This analysis is too restrictive since it has been generally held that exclusions from gross income are not limited to the enumerated exceptions.  …


In determining whether the expense-paid trip was income within § 61, we must look to the tests that have been developed under this section. The concept of economic gain to the taxpayer is key to § 61. H. Simons, Personal Income Taxation 51 (1938); J. Sneed, The Configurations of Gross Income 8 (1967). This concept contains two distinct requirements: There must be an economic gain, and this gain must primarily benefit the taxpayer personally. In some cases, as in the case of an expense-paid trip, there is no direct economic gain, but there is indirect economic gain inasmuch as a benefit has been received without a corresponding diminution of wealth. Yet even if expense-paid items, as meals and lodging, are received by the taxpayer, the value of these items will not be gross income, even though the employee receives some incidental benefit, if the meals and lodging are primarily for the convenience of the employer. See Int. Rev. Code of 1954, § 119.


… [T]here is no evidence in the record to indicate that the trip was an award for past services since Mr. Gotcher was not an employee of VW of Germany and he did nothing to earn that part of the trip paid by Economy Motors.


The trip was made in 1959 when VW was attempting to expand its local dealerships in the United States. The ‘buy American’ campaign and the fact that the VW people felt they had a ‘very ugly product’ prompted them to offer these tours of Germany to prospective dealers. … VW operations were at first so speculative that cars had to be consigned with a repurchase guarantee. In 1959, when VW began to push for its share of the American market, its officials determined that the best way to remove the apprehension about this foreign product was to take the dealer to Germany and have him see his investment first-hand. It was believed that once the dealer saw the manufacturing facilities and the stability of the ‘new Germany’ he would be convinced that VW was for him. Furthermore, VW considered the expenditure justified because the dealer was being asked to make a substantial investment of his time and money in a comparatively new product. Indeed, after taking the trip, VW required him to acquire first-class facilities. … VW could not have asked that this upgrading be done unless it convinced the dealer that VW was here to stay. Apparently these trips have paid off since VW’s sales have skyrocketed and the dealers have made their facilities top-rate operations under the VW requirements for a standard dealership.


The activities in Germany support the conclusion that the trip was oriented to business. The Government makes much of the fact that the travel brochure allocated only two of the twelve days to the touring of VW factories. This argument ignores the uncontradicted evidence that not all of the planned activities were in the brochure. There is ample support for the trial judge’s finding that a substantial amount of time was spent touring VW facilities and visiting local dealerships. VW had set up these tours with local dealers so that the travelers could discuss how the facilities were operated in Germany. Mr. Gotcher took full advantage of this opportunity and even used some of his ‘free time’ to visit various local dealerships. Moreover, at almost all of the evening meals VW officials gave talks about the organization and passed out literature and brochures on the VW story.


Some of the days were not related to touring VW facilities, but that fact alone cannot be decisive. The dominant purpose of the trip is the critical inquiry and some pleasurable features will not negate the finding of an overall business purpose. [citation omitted] Since we are convinced that the agenda related primarily to business and that Mr. Gotcher’s attendance was prompted by business considerations, the so-called sightseeing complained of by the Government is inconsequential. [citation omitted] Indeed, the district court found that even this touring of the countryside had an indirect relation to the business since the tours were not typical sightseeing excursions but were connected to the desire of VW that the dealers be persuaded that the German economy was stable enough to justify investment in a German product. We cannot say that this conclusion is clearly erroneous. Nor can we say that the enthusiastic literary style of the brochures negates a dominant business purpose. It is the business reality of the total situation, not the colorful expressions in the literature, that controls. Considering the record, the circumstances prompting the trip, and the objective achieved, we conclude that the primary purpose of the trip was to induce Mr. Gotcher to take out a VW dealership interest.


The question, therefore, is what tax consequences should follow from an expense-paid trip that primarily benefits the party paying for the trip. In several analogous situations the value of items received by employees has been excluded from gross income when these items were primarily for the benefit of the employer. Section 119 excludes from gross income of an employee the value of meals and lodging furnished to him for the convenience of the employer. Even if these items were excluded by the 1954 Code, the Treasury and the courts recognized that they should be excluded from gross income. Thus it appears that the value of any trip that is paid by the employer or by a businessman primarily for his own benefit should be excluded from gross income of the payee on similar reasoning. [citations omitted]


In the recent case of Allen J. McDonnell, 26 T.C.M. 115, Tax Ct. Mem. 1967-68, a sales supervisor and his wife were chosen by lot to accompany a group of contest winners on an expense-paid trip to Hawaii. In holding that the taxpayer had received no income, the Tax Court noted that he was required by his employer to go and that he was serving a legitimate business purpose though he enjoyed the trip. The decision suggests that in analyzing the tax consequences of an expense-paid trip one important factor is whether the traveler had any choice but to go. Here, although the taxpayer was not forced to go, there is no doubt that in the reality of the business world he had no real choice. The trial judge reached the same conclusion. He found that the invitation did not specifically order the dealers to go, but that as a practical matter it was an order or directive that if a person was going to be a VW dealer, sound business judgment necessitated his accepting the offer of corporate hospitality. So far as Economy Motors was concerned, Mr. Gotcher knew that if he was going to be a part-owner of the dealership, he had better do all that was required to foster good business relations with VW. Besides having no choice but to go, he had no control over the schedule or the money spent. VW did all the planning. In cases involving noncompensatory economic gains, courts have emphasized that the taxpayer still had complete dominion and control over the money to use it as he wished to satisfy personal desires or needs. Indeed, the Supreme Court has defined income as accessions of wealth over which the taxpayer has complete control. Commissioner of Internal Revenue v. Glenshaw Glass Co., supra. Clearly, the lack of control works in the taxpayer’s favor here.


McDonnell also suggests that one does not realize taxable income when he is serving a legitimate business purpose of the party paying the expenses. The cases involving corporate officials who have traveled or entertained clients at the company’s expense are apposite. Indeed, corporate executives have been furnished yachts, Challenge Mfg. Co. v. Commissioner, 1962, 37 T.C. 650, taken safaris as part of an advertising scheme, Sanitary Farms Dairy, Inc., 1955 25 T.C. 463, and investigated business ventures abroad, but have been held accountable for expenses paid only when the court was persuaded that the expenditure was primarily for the officer’s personal pleasure. On the other hand, when it has been shown that the expenses were paid to effectuate a legitimate corporate end and not to benefit the officer personally, the officer has not been taxed though he enjoyed and benefited from the activity. Thus, the rule is that the economic benefit will be taxable to the recipient only when the payment of expenses serves no legitimate corporate purposes. [citation omitted] The decisions also indicate that the tax consequences are to be determined by looking to the primary purpose of the expenses and that the first consideration is the intention of the payor. The Government in argument before the district court agreed that whether the expenses were income to taxpayers is mainly a question of the motives of the people giving the trip. Since this is a matter of proof, the resolution of the tax question really depends on whether Gotcher showed that his presence served a legitimate corporate purpose and that no appreciable amount of time was spent for his personal benefit and enjoyment. [citation omitted]


Examination of the record convinces us that the personal benefit to Gotcher was clearly subordinate to the concrete benefits to VW. The purpose of the trip was to push VW in America and to get dealers to invest more money and time in their dealerships. Thus, although Gotcher got some ideas that helped him become a better dealer, there is no evidence that this was the primary purpose of the trip. Put another way, this trip was not given as a pleasurable excursion through Germany or as a means of teaching taxpayer the skills of selling. The personal benefits and pleasure were incidental to the dominant purpose of improving VW’s position on the American market and getting people to invest money.


The corporate-executive decisions indicate that some economic gains, though not specifically excluded from § 61, may nevertheless escape taxation. They may be excluded even though the entertainment and travel unquestionably give enjoyment to the taxpayer and produce indirect economic gains. When this indirect economic gain is subordinate to an overall business purpose, the recipient is not taxed. We are convinced that the personal benefit to Mr. Gotcher from the trip was merely incidental to VW’s sales campaign.


As for Mrs. Gotcher, the trip was primarily vacation. She did not make the tours with her husband to see the local dealers or attend discussions about the VW organization. This being so, the primary benefit of the expense-paid trip for the wife went to Mr. Gotcher in that he was relieved of her expenses. He should therefore be taxed on the expenses attributable to his wife. [citation omitted] Nor are the expenses deductible since the wife’s presence served no bona fide business purpose for her husband. Only when the wife’s presence is necessary to the conduct of the husband’s business are her expenses deductible under § 162. [citation omitted] Also, it must be shown that the wife made the trip only to assist her husband in his business. …


Affirmed in part; reversed in part.


JOHN R. BROWN, Chief Judge (concurring):



Attributing income to the little wife who was neither an employee, a prospective employee, nor a dealer, for the value of the trip she neither planned nor chose still bothers me. If her uncle had paid for the trip, would it not have been a pure gift, not income? Or had her husband out of pure separate property given her the trip would the amount over and above the cost of Texas bed and board have been income? I acquiesce now, confident that for others in future cases on a full record the wife, as now does the husband, also will overcome.




Taxability of a Price Reduction: What happens when taxpayer is able to purchase a computer that “normally” retails for $1000 for $800 during a “computer blowout sale?” Does our taxpayer enjoy a $200 accession to wealth? Answer: No.


A “mere reduction in price” is not taxable income. A contrary rule would raise insurmountable problems of value determination. Recall the alternative definitions of “value” in chapter 1. Perhaps an insufficient number of persons were willing to pay $1000 for the computer $800 in the first place.





Notes and Questions:


1. What tests does the court state to determine whether the trip was an “accession to wealth?”


2. If the procurement of a benefit “primarily benefits” the payor rather than the recipient, has the recipient really realized an “accession to wealth” whose value should be measured by its cost?


3. How important should the absence of control over how money is spent be in determining whether taxpayer has realized an accession to wealth on which s/he should pay taxes? What factors are important in determining whether a non-compensatory benefit is an “accession to wealth?”


4. Is Gotcher a case where taxpayer did not receive any “gross income” or a case where taxpayer did receive “gross income” that the Code excluded? It might make a difference.


• What happened to our second principle – that all income is taxed once unless an exception is specifically found in the Code?


5. Can you think of any reasons other than those offered by Judge Brown for not including the cost of Mrs. Gotcher’s trip in Mr. Gotcher’s gross income? How does (can) her trip fit within the rationale that excludes the value of Mr. Gotcher’s trip from his gross income?


• Does Judge Brown’s analysis support his conclusion?


6. This case involved a prospective investor. The recipient may also be a prospective employee or a prospective customer.


7. Back to windfalls, plus some dumb luck …


Cesarini v. United States, 296 F. Supp. 3 (N.D. Ohio 1969)



YOUNG, District Judge.




… Plaintiffs are husband and wife, and live within the jurisdiction of the United States District Court for the Northern District of Ohio. In 1957, the plaintiffs purchased a used piano at an auction sale for approximately $15.00, and the piano was used by their daughter for piano lessons. In 1964, while cleaning the piano, plaintiffs discovered the sum of $4,467.00 in old currency, and since have retained the piano instead of discarding it as previously planned. Being unable to ascertain who put the money there, plaintiffs exchanged the old currency for new at a bank, and reported a sum of $4,467.00 on their 1964 joint income tax return as ordinary income from other sources. On October 18, 1965, plaintiffs filed an amended return …, this second return eliminating the sum of $4,467.00 from the gross income computation, and requesting a refund in the amount of $836.51, the amount allegedly overpaid as a result of the former inclusion of $4,467.00 in the original return for the calendar year of 1964. … [T]he Commissioner of Internal Revenue rejected taxpayers’ refund claim in its entirety, and plaintiffs filed the instant action in March of 1967.


Plaintiffs make three alternative contentions in support of their claim that the sum of $836.51 should be refunded to them. First, that the $4,467.00 found in the piano is not includable in gross income under § 61 of the Internal Revenue Code. (26 U.S.C. § 61) Secondly, even if the retention of the cash constitutes a realization of ordinary income under § 61, it was due and owing in the year the piano was purchased, 1957, and by 1964, the statute of limitations provided by 26 U.S.C. § 6501 had elapsed. And thirdly, that if the treasure trove money is gross income for the year 1964, it was entitled to capital gains treatment under § 1221 of Title 26. The Government, by its answer and its trial brief, asserts that the amount found in the piano is includable in gross income under § 61(a) of Title 26, U.S.C., that the money is taxable in the year it was actually found, 1964, and that the sum is properly taxable at ordinary income rates, not being entitled to capital gains treatment under 26 U.S.C. §§ 2201 et seq.


… [T]his Court has concluded that the taxpayers are not entitled to a refund of the amount requested, nor are they entitled to capital gains treatment on the income item at issue.


The starting point in determining whether an item is to be included in gross income is, of course, § 61(a) …, and that section provides in part: “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:” * * *’


Subsections (1) through (15) of § 61(a) then go on to list fifteen items specifically included in the computation of the taxpayers’ gross income, and Part II of Subchapter B of the 1954 Code (§§ 71 et seq.) deals with other items expressly included in gross income. While neither of these listings expressly includes the type of income which is at issue in the case at bar, Part III of Subchapter B (§§ 101 et seq.) deals with items specifically excluded from gross income, and found money is not listed in those sections either. This absence of express mention in any code sections necessitates a return to the ‘all income from whatever source’ language of § 61(a) of the code, and the express statement there that gross income is ‘not limited to’ the following fifteen examples. …


The decisions of the United States Supreme Court have frequently stated that this broad all-inclusive language was used by Congress to exert the full measure of its taxing power under the Sixteenth Amendment to the United States Constitution. [citations omitted]


In addition, the Government in the instant case cites and relies upon an I.R.S. Revenue Ruling which is undeniably on point:


‘The finder of treasure-trove is in receipt of taxable income, for Federal income tax purposes, to the extent of its value in United States Currency, for the taxable year in which it is reduced to undisputed possession.’ Rev. Rul. 61, 1953-1, Cum. Bull. 17.




… While it is generally true that revenue rulings may be disregarded by the courts if in conflict with the code and the regulations, or with other judicial decisions, plaintiffs in the instant case have been unable to point to any inconsistency between the gross income sections of the code, the interpretation of them by the regulations and the Courts, and the revenue ruling which they herein attack as inapplicable. On the other hand, the United States has shown consistency in the letter and spirit between the ruling and the code, regulations, and court decisions.


Although not cited by either party, and noticeably absent from the Government’s brief, the following Treasury Regulation appears in the 1964 Regulations, the year of the return in dispute:


‘§ 1.61-14 Miscellaneous items of gross income.


‘(a) In general. In addition to the items enumerated in section 61(a), there are many other kinds of gross income * * *. Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession.’


… This Court is of the opinion that Treas. Reg. § 1.61-14(a) is dispositive of the major issue in this case if the $4,467.00 found in the piano was ‘reduced to undisputed possession’ in the year petitioners reported it, for this Regulation was applicable to returns filed in the calendar year of 1964.


This brings the Court to the second contention of the plaintiffs: that if any tax was due, it was in 1957 when the piano was purchased, and by 1964 the Government was blocked from collecting it by reason of the statute of limitations. Without reaching the question of whether the voluntary payment in 1964 constituted a waiver on the part of the taxpayers, this Court finds that the $4,467.00 sum was properly included in gross income for the calendar year of 1964. Problems of when title vests, or when possession is complete in the field of federal taxation, in the absence of definitive federal legislation on the subject, are ordinarily determined by reference to the law of the state in which the taxpayer resides, or where the property around which the dispute centers in located. Since both the taxpayers and the property in question are found within the State of Ohio, Ohio law must govern as to when the found money was ‘reduced to undisputed possession’ within the meaning of Treas. Reg. 1.61-14 and Rev. Rul. 61-53-1, Cum. Bull. 17.


In Ohio, there is no statute specifically dealing with the rights of owners and finders of treasure trove, and in the absence of such a statute the common-law rule of England applies, so that ‘title belongs to the finder as against all the world except the true owner.’ Niederlehner v. Weatherly, 78 Ohio App. 263, 29 N.E.2d 787 (1946), appeal dismissed, 146 Ohio St. 697, 67 N.E.2d 713 (1946). The Niederlehner case held, inter alia, that the owner of real estate upon which money is found does not have title against the finder. Therefore, in the instant case if plaintiffs had resold the piano in 1958, not knowing of the money within it, they later would not be able to succeed in an action against the purchaser who did discover it. Under Ohio law, the plaintiffs must have actually found the money to have superior title over all but the true owner, and they did not discover the old currency until 1964. Unless there is present a specific state statute to the contrary, the majority of jurisdictions are in accord with the Ohio rule. Therefore, this Court finds that the $4,467.00 in old currency was not ‘reduced to undisputed possession’ until its actual discovery in 1964, and thus the United States was not barred by the statute of limitations from collecting the $836.51 in tax during that year.


Finally, plaintiffs’ contention that they are entitled to capital gains treatment upon the discovered money must be rejected. [Taxpayers’ gain did not result from the sale or exchange of a capital asset.] …


Notes and Questions:


1. How did the court treat Rev. Rul. 1953-1? What does this tell you about the legal status of a revenue ruling?


2. What role did state law play in the resolution of this case? Why was it necessary to invoke it?


3. What tax norms would the court have violated if it had held in favor of the Cesarinis?




Other statutory items of gross income: Recall from chapter 1 that the Code specifically names items of gross income in §§ 71-90. You should at least peruse the table of contents to your Code to get an idea of what Congress has deemed worthy of specific inclusion. We will take up some of these provisions in a bit more depth. These Code sections often define the precise extent to which an item is (and so implicitly the extent which it is not) gross income. Sometimes Congress is clarifying or stating a position on a point on which courts had previously ruled otherwise. For example:


Prizes and Awards: Read § 74(a). With only the exceptions noted in §§ 74(b and c), gross income includes amounts received as prizes and awards. A significant question with regard to non-cash prizes is their valuation. For reasons you can readily determine, valuation must be an objective matter. However, this does not mean that the fmv of a prize to the recipient is necessarily the price paid by the giver. For example, most persons would agree that merely driving a new automobile from the dealer’s lot substantially reduces its value. The winner of an automobile should be given at least some credit for this fact. See McCoy v. CIR, 38 T.C. 841 (1962) (prize of automobile). Taxpayer might demonstrate the value that she or he places on the prize by trading it as quickly as possible after receiving it for something she or he values more – in economic terms, a “revealed preference.” See McCoy, supra (taxpayer traded automobile for $1000 cash plus a different new automobile); Turner v. CIR, T.C. Memo. 1954-38 (taxpayer exchanged two first-class steamship tickets for four tourist class tickets).





B. Section 61(a)(3): Gains Derived from Dealings in Property



Section 61(a)(3) includes in a taxpayer’s “gross income” “gains derived from dealings in property.” This provision does not tell us how to determine what those gains might be. For that, we turn to §§ 1001(a and b). Read it. (The word “over” frequently appears in the Code as a directive to subtract whatever is described.) Section 1001(a) directs you to § 1011. Read it. Section 1011 directs you to §§ 1012 and 1016. Read § 1012(a) and 1016(a).




Fluctuations in Value: The value of property may fluctuate over the time taxpayer owns it. If its value increases, taxpayer must recognize taxable gain upon its sale. If its value decreases, § 165(a) might permit taxpayer to reduce his or her gross income by the amount of the loss upon its sale. If its value increases and taxpayer could have sold it but does not – does taxpayer realize a tax loss when s/he later sells it for more than his/her basis but less than the fmv it once had?





The effect of subtracting “adjusted basis” is to exclude that amount from taxpayer’s “gross income” and so from his/her income tax burden. That money of course had already been subject to income tax at the time the taxpayer put it into his/her “store of property rights” and so should not be subject to tax again.


We begin with a case dealing with a loss from a dealing in property.


Hort v. CIR, 313 U.S. 28 (1941)



MR. JUSTICE MURPHY delivered the opinion of the Court.




Petitioner acquired the property, a lot and ten-story office building, by devise from his father in 1928. At the time he became owner, the premises were leased to a firm which had sublet the main floor to the Irving Trust Co. In 1927, five years before the head lease expired, the Irving Trust Co. and petitioner’s father executed a contract in which the latter agreed to lease the main floor and basement to the former for a term of fifteen years at an annual rental of $25,000, the term to commence at the expiration of the head lease.


In 1933, the Irving Trust Co. found it unprofitable to maintain a branch in petitioner’s building. After some negotiations, petitioner and the Trust Co. agreed to cancel the lease in consideration of a payment to petitioner of $140,000. Petitioner did not include this amount in gross income in his income tax return for 1933. On the contrary, he reported a loss of $21,494.75 on the theory that the amount he received as consideration for the cancellation was $21,494.75 less than the difference between the present value of the unmatured rental payments and the fair rental value of the main floor and basement for the unexpired term of the lease. …


The Commissioner included the entire $140,000 in gross income, disallowed the asserted loss, … and assessed a deficiency. The Board of Tax Appeals affirmed. 39 B.T.A. 922. The Circuit Court of Appeals affirmed per curiam … [W]e granted certiorari limited to the question whether, “in computing net gain or loss for income tax purposes, a taxpayer [can] offset the value of the lease canceled against the consideration received by him for the cancellation.”




The amount received by petitioner for cancellation of the lease must be included in his gross income in its entirety. Section [61]  … expressly defines gross income to include “gains, profits, and income derived from … rent, … or gains or profits and income from any source whatever.” Plainly this definition reached the rent paid prior to cancellation, just as it would have embraced subsequent payments if the lease had never been canceled. It would have included a prepayment of the discounted value of unmatured rental payments whether received at the inception of the lease or at any time thereafter. Similarly, it would have extended to the proceeds of a suit to recover damages had the Irving Trust Co. breached the lease instead of concluding a settlement. [citations omitted] That the amount petitioner received resulted from negotiations ending in cancellation of the lease, rather than from a suit to enforce it, cannot alter the fact that basically the payment was merely a substitute for the rent reserved in the lease. So far as the application of [§ 61(a)] is concerned, it is immaterial that petitioner chose to accept an amount less than the strict present value of the unmatured rental payments, rather than to engage in litigation, possibly uncertain and expensive.


The consideration received for cancellation of the lease was not a return of capital. We assume that the lease was “property,” whatever that signifies abstractly. … Simply because the lease was “property,” the amount received for its cancellation was not a return of capital, quite apart from the fact that “property” and “capital” are not necessarily synonymous in the Revenue Act of 1932 or in common usage. Where, as in this case, the disputed amount was essentially a substitute for rental payments which [§ 61(a)] expressly characterizes as gross income, it must be regarded as ordinary income, and it is immaterial that, for some purposes, the contract creating the right to such payments may be treated as “property” or “capital.”




We conclude that petitioner must report as gross income the entire amount received for cancellation of the lease, without regard to the claimed disparity between that amount and the difference between the present value of the unmatured rental payments and the fair rental value of the property for the unexpired period of the lease. The cancellation of the lease involved nothing more than relinquishment of the right to future rental payments in return for a present substitute payment and possession of the leased premises. Undoubtedly it diminished the amount of gross income petitioner expected to realize, but, to that extent, he was relieved of the duty to pay income tax. Nothing in [§ 165] indicates that Congress intended to allow petitioner to reduce ordinary income actually received and reported by the amount of income he failed to realize. [citations omitted] We may assume that petitioner was injured insofar as the cancellation of the lease affected the value of the realty. But that would become a deductible loss only when its extent had been fixed by a closed transaction. [citations omitted]


The judgment of the Circuit Court of Appeals is affirmed.


Notes and Questions:


1. Taxpayer measured his gain/loss with the benefit of the bargain as his reference point. An accountant or financial officer would not evaluate the buyout of the lease in this case any differently than taxpayer did. If a lessor’s interest has a certain value and the lessor sells it for less than that value, why can’t the lessor recognize a tax loss?


• Evidently it was a good lease for the lessor. The present value of the contracted rents was greater than the fair rental value of the property.


• $140,000 was $21,500 less than the anticipated value of the lease.




Lump sum payments: On occasion, taxpayer may accept a lump sum payment in lieu of receiving periodic payments. The tax law characterizes the lump sum in the same manner as it would have characterized the periodic payments. For example, a life insurance salesman who sells his/her right to receive future commissions for a lump sum must treat the lump sum as commission income. We saw the Court apply this principle in Glenshaw Glass when it treated a lump sum payment in lieu of profits as if it were profit.





2. The Tax Code taxes all income once unless specifically provided otherwise. Basis is the means by which a taxpayer keeps score with the government concerning what accessions to wealth have already been subject to tax.


• How does the Court’s opinion implement these principles?


• How did taxpayer’s contentions fail to implement these principles?


• What exactly was taxpayer’s basis in its lessor’s interest in the leasehold?


C. Barter



Now suppose that instead of accepting money in exchange for property or services, taxpayer accepts services for services, property for property, property for services, or services for property.


Rev. Rul. 79-24








Situation 1. In return for personal legal services performed by a lawyer for a housepainter, the housepainter painted the lawyer’s personal residence. Both the lawyer and the housepainter are members of a barter club, an organization that annually furnishes its members a directory of members and the services they provide. All the members of the club are professionals or trades persons. Members contact other members directly and negotiate the value of the services to be performed.


Situation 2. An individual who owned an apartment building received a work of art created by a professional artist in return for the rent-free use of an apartment for six months by the artist.




The applicable sections of the Internal Revenue Code of 1954 and the Income Tax Regulations thereunder are 61(a) and 1.61-2, relating to compensation for services.


Section 1.61-2(d)(1) of the regulations provides that if services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income. If the services were rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.




Situation 1. The fair market value of the services received by the lawyer and the housepainter are includible in their gross incomes under section 61 of the Code.


Situation 2. The fair market value of the work of art and the six months fair rental value of the apartment are includible in the gross incomes of the apartment-owner and the artist under section 61 of the Code.


Notes and Questions:


1. Each party to a barter transaction gave up something and received something. If the fmv of what a party gives up is different from the value of what s/he received, it is the value of what taxpayer receives that matters. Read the Law and Holdings carefully. Section 1001(a) also requires this. This implies that two parties to a transaction may realize different amounts.


• Why would it be wrong to measure the amount realized by what taxpayer gave up in a barter transaction? Consider –


2. (continuing note 1): Let’s say that the fmv of the painting was $6000. The fmv of the rent was $7000. We say that we tax income once – but we don’t tax it more than once. In the following questions, keep track of what the taxpayer has and on how much income s/he has paid income tax.


• What should be the apartment-owner’s taxable gain from exchanging rent for the painting?


• What should be the apartment-owner’s basis in the painting s/he received?


• What is the apartment-owner’s taxable gain if s/he sells the painting immediately upon receipt for its fmv?


3. Sections 61(a) lists several forms that gross income may take. The Code does not treat all forms of gross income the same. Different rates of tax may apply to different forms of gross income. Or, the Code might not – in certain circumstances – tax some forms of gross income at all. Thus there are reasons that we should not (always) treat gross income as a big hodge-podge of money. In the following case, the court distinguishes between a gain that taxpayer derived from dealings in property from gains that taxpayer derived from a discharge of his/her debt. Determine what was at issue in Gehl, what the parties argued, and why it mattered.


United States v. Gehl, 50 F.3d 12 (unpublished), 1995 WL 115589 (CA8), cert. denied, 516 U.S. 899 (1995)







BOGUE, Senior District Judge.


Taxpayers James and Laura Gehl (taxpayers) appeal from an adverse decision in the United States Tax Court finding deficiencies in their income taxes for 1988 and 1989. For the reasons stated below, we affirm.




Prior to the events in issue, the taxpayers borrowed money from the Production Credit Association of the Midlands (PCA). Mortgages on a 218 acre family farm were given to the PCA to secure the recourse loan. As of December 30, 1988, the taxpayers were insolvent and unable to make the payments on the loan, which had an outstanding balance of $152,260. The transactions resolving the situation between the PCA and the taxpayers form the basis of the current dispute.


Pursuant to a restructuring agreement, taxpayers, by deed in lieu of foreclosure, conveyed 60 acres of the farm land to the PCA on December 30, 1988, in partial satisfaction of the debt. The taxpayers basis in the 60 acres was $14,384 and they were credited with $39,000 towards their loan, the fair market value of the land. On January 4, 1989, taxpayers conveyed, also by deed in lieu of foreclosure, an additional 141 acres of the mortgaged farm land to the PCA in partial satisfaction of the debt. Taxpayers basis in the 141 acres was $32,000 and the land had a fair market value of $77,725. Taxpayers also paid $6,123 in cash to the PCA to be applied to their loan. The PCA thereupon forgave the remaining balance of the taxpayers’ loan, $29,412. Taxpayers were not debtors under the Bankruptcy Code during 1988 or 1989, but were insolvent both before and after the transfers and discharge of indebtedness.


After an audit, the Commissioner of Revenue (Commissioner) determined tax deficiencies of $6,887 for 1988 and $13,643 for 1989 on the theory that the taxpayers had realized a gain on the disposition of their farmland in the amount by which the fair market value of the land exceeded their basis in the same at the time of the transfer (gains of $24,616 on the 60 acre conveyance and $45,645 on the conveyance of the 141 acre conveyance). The taxpayers petitioned the Tax Court for redetermination of their tax liability for the years in question contending that any gain they realized upon the transfer of their property should not be treated as income because they remained insolvent after the transactions.


The Tax Court found in favor of the Commissioner. In doing so, the court “bifurcated” its analysis of the transactions, considering the transfers of land and the discharge of the remaining debt separately. The taxpayers argued that the entire set of transactions should be considered together and treated as income from the discharge of indebtedness. As such, any income derived would be excluded as the taxpayers remained insolvent throughout the process. 26 U.S.C. § 108(a)(1). As to the discharge of indebtedness, the court determined that because the taxpayers remained insolvent after their debt was discharged, no income would be attributable to that portion of the restructuring agreement.


On the other hand, the court found the taxpayers to have received a gain includable as gross income from the transfers of the farm land (determined by the excess of the respective fair market values over the respective basis). This gain was found to exist despite the continued insolvency in that the gain from the sale or disposition of land is not income from the discharge of indebtedness. The taxpayers appealed.




We review the Tax Court’s interpretation of law de novo. [citation omitted] Discussion of this case properly begins with an examination of I.R.C. § 61 which defines gross income under the Code. In order to satisfy their obligation to the PCA, the taxpayers agreed to participate in an arrangement which could potentially give rise to gross income in two distinct ways.36 I.R.C. § 61(a)(3) provides that for tax purposes, gross income includes “gains derived from dealings in property.” Likewise, income is realized pursuant to I.R.C. § 61(a)(12) for “income from discharge of indebtedness.”



There can be little dispute with respect to Tax Court’s treatment of the $29,412 portion of the debt forgiven subsequent to the transfers of land and cash. The Commissioner stipulated that under I.R.C. § 108(a)(1)(B),37 the so-called “insolvency exception,” the taxpayers did not have to include as income any part of the indebtedness that the PCA forgave. The $29,412 represented the amount by which the land and cash transfers fell short of satisfying the outstanding debt. The Tax Court properly found this amount to be excluded.



Further, the Tax Court’s treatment of the land transfers, irrespective of other portions of the restructuring agreement, cannot be criticized. Section 1001 governs the determination of gains and losses on the sale or exchange of property. Section 1001(a) provides that “[t]he gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis …” The taxpayers contend that because the disposition of their land was compulsory and that they had no discretion with respect to the proceeds, the deeds in lieu of foreclosure are not “sales” for the purposes of § 1001. We disagree. A transfer of property by deed in lieu of foreclosure constitutes a “sale or exchange” for federal income tax purposes. Allan v. Commissioner of Revenue, 86 F.C. 655, 659-60, aff’d. 856 F.2d 1169, 1172 (8th Cir. 1988) (citations omitted). The taxpayers’ transfers by deeds in lieu of foreclosure of their land to the PCA in partial satisfaction of the recourse debt were properly considered sales or exchanges for purposes of § 1001.


Taxpayers also appear to contend that under their circumstances, there was no “amount realized” under I.R.C. §§ 1001(a-b) and thus, no “gain” from the land transfers as the term is used in I.R.C. § 61(a)(3). Again, we must disagree. The amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. Treas. Reg. § 1.1001-2(a)(1). Simply because the taxpayers did not actually receive any cash proceeds from the land transfers does not mean there was no amount realized. Via the land transfers, they were given credit toward an outstanding recourse loan to the extent of the land’s fair market value. This loan had to be paid back. It is clear that the transfers of land employed to satisfy that end must be treated the same as receiving money from a sale. In this case the land transfers were properly considered “gains derived from dealings in property” to the extent the fair market value in the land exceeded the taxpayers’ basis in said land. I.R.C. §§ 61(a)(3), 1001(a).


The taxpayers’ primary and fundamental argument in this case is the Tax Court’s refusal to treat the entire settlement of their loan, including the land transfers, as coming within the scope of I.R.C. § 108. As previously stated, § 108 and attending Treasury Regulations act to exclude income from the discharge of indebtedness where the taxpayer thereafter remains insolvent. The taxpayers take issue with the bifurcated analysis conducted by the Tax Court and contend that, because of their continued insolvency, § 108 acts to exclude any income derived from the various transactions absolving their debt to the PCA.


As an initial consideration, the taxpayers read the insolvency exception of § 108 too broadly. I.R.C. § 61 provides an [sic] non-exclusive list of fifteen items which give rise to income for tax purposes, including income from discharge of indebtedness. Of the numerous potential sources of income, § 108 grants an exclusion to insolvent taxpayers only as to income from the discharge of indebtedness. It does not preclude the realization of income from other activities or sources.


While § 108 clearly applied to a portion of the taxpayers’ loan restructuring agreement, the land transfers were outside the section’s scope and were properly treated independently. [citation omitted]


There is ample authority to support Tax Court’s bifurcated analysis and substantive decision rendered with respect to the present land transfers. The Commissioner relies heavily on Treas. Reg. § 1.1001-2 and example 8 contained therein, which provides:


(a) Inclusion in amount realized.-(1) * * *


(2) Discharge of indebtedness. The amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under section 61(a)(12). * * *


(c) Examples * * *


Example (8). In 1980, F transfers to a creditor an asset with a fair market value of $6,000 and the creditor discharges $7,500 of indebtedness for which F is personally liable. The amount realized on the disposition of the asset is its fair market value ($6,000). In addition, F has income from the discharge of indebtedness of $1,500 ($7,500-$6,000).


We believe the regulation is controlling and serves … to provide support for the decision rendered by the Tax Court.38





For the reasons stated, we affirm the decision of the Tax Court.


Notes and Questions:


1. Section 61(a) presents a comprehensive definition of “gross income.” However, the fifteen enumerated types or sources of income are not necessarily subject to the same rate of tax, and other provisions may exclude certain types of income from income subject to tax altogether. Naturally, taxpayers would prefer to characterize their income as of a type or from a source not subject to income tax. Under certain circumstances, § 108 excludes discharge of indebtedness income from income tax. See chapter 3 infra. For these reasons, the type or source of income can matter greatly.


2. Taxpayer may transfer a piece of appreciated (or depreciated) property to another to satisfy an obligation or make a payment. Taxpayer might alternatively have sold the property for its fmv. The gain derived from the sale would be subject to income tax. Taxpayer could then pay the cash s/he realized to the obligee or payee. The result should be no different if taxpayer simply transfers the property directly to the obligee or payee. The court recognized this when it stated:




Giving property as payment: The use of appreciated (or depreciated) property to pay for something is a recognition event. Why?





It is clear that the transfers of land employed to satisfy [an obligation or make a payment] must be treated the same as receiving money from a sale. In this case the land transfers were properly considered “gains derived from dealings in property” to the extent the fair market value in the land exceeded the taxpayers’ basis in said land. I.R.C. §§ 61(a)(3), 1001(a).


3. Notice that if taxpayers’ views in Gehl had prevailed, they would have realized the benefit of the appreciation in the value of their property (i.e., an accession to wealth) without that accession ever being subject to tax – contrary to the first of the three principles stated chapter 1 that you should know by now.


4. Read Reg. § 1.61-2(d)(1 and 2(i)) and § 83(a).


• Taxpayer performed accounting services over the course of one year for Baxter Realty. The fmv of these services was $15,000. Taxpayer billed Baxter Realty for $15,000. Unfortunately, Baxter Realty was short on cash and long on inventory, which included a tract of land known as Blackacre. The fmv of Blackacre was $20,000. Its cost to Baxter Realty was $11,000. Taxpayer agreed to accept Blackacre as full payment for the bill. Six months later, Taxpayer sold Blackacre to an unrelated third person for $22,000.


1. How much must Taxpayer report as gross income from the receipt of Blackacre as payment for his/her services?


2. How much must Taxpayer report as gross income derived from the sale of Blackacre?


3. How much must Baxter Realty report as gross income derived from its dealings in Blackacre?


D. Improvements to Leaseholds and the Time Value of Money



Helvering v. Bruun, 309 U.S. 461 (1940)



MR. JUSTICE ROBERTS delivered the opinion of the Court.




… [O]n July 1, 1915, the respondent, as owner, leased a lot of land and the building thereon for a term of ninety-nine years.


The lease provided that the lessee might at any time, upon giving bond to secure rentals accruing in the two ensuing years, remove or tear down any building on the land, provided that no building should be removed or torn down after the lease became forfeited, or during the last three and one-half years of the term. The lessee was to surrender the land, upon termination of the lease, with all buildings and improvements thereon.


In 1929, the tenant demolished and removed the existing building and constructed a new one which had a useful life of not more than fifty years. July 1, 1933, the lease was cancelled for default in payment of rent and taxes, and the respondent regained possession of the land and building.




“… [At] said date, July 1, 1933, the building which had been erected upon said premises by the lessee had a fair market value of $64,245.68, and … the unamortized cost of the old building, which was removed from the premises in 1929 to make way for the new building, was $12,811.43, thus leaving a net fair market value as at July 1, 1933, of $51,434.25, for the aforesaid new building erected upon the premises by the lessee.”


On the basis of these facts, the petitioner determined that, in 1933, the respondent realized a net gain of $51,434.25. The Board overruled his determination, and the Circuit Court of Appeals affirmed the Board’s decision.


The course of administrative practice and judicial decision in respect of the question presented has not been uniform. In 1917, the Treasury ruled that the adjusted value of improvements installed upon leased premises is income to the lessor upon the termination of the lease. The ruling was incorporated in two succeeding editions of the Treasury Regulations. In 1919, the Circuit Court of Appeals for the Ninth Circuit held, in Miller v. Gearin, 258 F.2d 5, that the regulation was invalid, as the gain, if taxable at all, must be taxed as of the year when the improvements were completed.


The regulations were accordingly amended to impose a tax upon the gain in the year of completion of the improvements, measured by their anticipated value at the termination of the lease and discounted for the duration of the lease. Subsequently, the regulations permitted the lessor to spread the depreciated value of the improvements over the remaining life of the lease, reporting an aliquot part each year, with provision that, upon premature termination, a tax should be imposed upon the excess of the then value of the improvements over the amount theretofore returned.


In 1935, the Circuit Court of Appeals for the Second Circuit decided, in Hewitt Realty Co. v. Commissioner, 76 F.2d 880, that a landlord received no taxable income in a year, during the term of the lease, in which his tenant erected a building on the leased land. The court, while recognizing that the lessor need not receive money to be taxable, based its decision that no taxable gain was realized in that case on the fact that the improvement was not portable or detachable from the land, and, if removed, would be worthless except as bricks, iron, and mortar. It said, 76 F.2d 884: “The question, as we view it, is whether the value received is embodied in something separately disposable, or whether it is so merged in the land as to become financially a part of it, something which, though it increases its value, has no value of its own when torn away.” This decision invalidated the regulations then in force.


In 1938, this court decided M.E. Blatt Co. v. United States, 305 U. S. 267. There, in connection with the execution of a lease, landlord and tenant mutually agreed that each should make certain improvements to the demised premises and that those made by the tenant should become and remain the property of the landlord. The Commissioner valued the improvements as of the date they were made, allowed depreciation thereon to the termination of the leasehold, divided the depreciated value by the number of years the lease had to run, and found the landlord taxable for each year’s aliquot portion thereof. His action was sustained by the Court of Claims. The judgment was reversed on the ground that the added value could not be considered rental accruing over the period of the lease; that the facts found by the Court of Claims did not support the conclusion of the Commissioner as to the value to be attributed to the improvements after a use throughout the term of the lease, and that, in the circumstances disclosed, any enhancement in the value of the realty in the tax year was not income realized by the lessor within the Revenue Act.


The circumstances of the instant case differentiate it from the Blatt and Hewitt cases, but the petitioner’s contention that gain was realized when the respondent, through forfeiture of the lease, obtained untrammeled title, possession, and control of the premises, with the added increment of value added by the new building, runs counter to the decision in the Miller case and to the reasoning in the Hewitt case.


The respondent insists that the realty – a capital asset at the date of the execution of the lease – remained such throughout the term and after its expiration; that improvements affixed to the soil became part of the realty indistinguishably blended in the capital asset; that such improvements cannot be separately valued or treated as received in exchange for the improvements which were on the land at the date of the execution of the lease; that they are therefore in the same category as improvements added by the respondent to his land, or accruals of value due to extraneous and adventitious circumstances. Such added value, it is argued, can be considered capital gain only upon the owner’s disposition of the asset. The position is that the economic gain consequent upon the enhanced value of the recaptured asset is not gain derived from capital or realized within the meaning of the Sixteenth Amendment, and may not therefore be taxed without apportionment.


We hold that the petitioner was right in assessing the gain as realized in 1933.




The respondent cannot successfully contend that the definition of gross income in Sec. [61(a)] is not broad enough to embrace the gain in question. … He emphasizes the necessity that the gain be separate from the capital and separately disposable. …


While it is true that economic gain is not always taxable as income, it is settled that the realization of gain need not be in cash derived from the sale of an asset. Gain may occur as a result of exchange of property, payment of the taxpayer’s indebtedness, relief from a liability, or other profit realized from the completion of a transaction. The fact that the gain is a portion of the value of property received by the taxpayer in the transaction does not negative its realization.


Here, as a result of a business transaction, the respondent received back his land with a new building on it, which added an ascertainable amount to its value. It is not necessary to recognition of taxable gain that he should be able to sever the improvement begetting the gain from his original capital. If that were necessary, no income could arise from the exchange of property, whereas such gain has always been recognized as realized taxable gain.


Judgment reversed.




Notes and Questions:


1. Aliquot: a fractional part that is contained a precise number of times in the whole.


2. Why did everyone who had anything to do with this case subtract the unamortized cost of the old building from the fmv of the new building in determining taxpayer’s taxable income? After all, taxpayer does not own a building that no longer physically exists?


3. Sections 109/1019 reverse the holding of Bruun. Section 109 provides that taxpayer does not derive gross income upon termination of a lease by virtue of the fact that the lessee erected buildings or other improvements on the property. Section 1019 provides that taxpayer may not increase or decrease his/her/its adjusted basis in property because he/she/it received gross income that § 109 excludes. Is § 1019 necessary?


• What is conceptually wrong with §§ 109 and 1019? Isn’t there some untaxed consumption? Where?




The cost of deriving income and depreciation: Taxpayer should not be subject to tax on the costs that he/she/it incurs to earn income. The costs of supplies, e.g., fuel to operate a productive machine, represent consumption from which taxpayer derives income. The Code taxes only “net” income. It accomplishes this by granting taxpayer a deduction for such consumption. § 162. Suppose that taxpayer incurs a cost to purchase an asset that will produce income for many years, e.g., a building. Taxpayer’s taxable income would be subject to (enormous) distortion if he/she/it reduced his/her/its gross income by the cost of such an asset in the year he/she/it purchased it. The Code treats such a purchase as an investment – a mere conversion in the form in which taxpayer holds his/her/its wealth. A taxpayer’s mere conversion of the form in which he/she/it holds wealth is not a taxable event. Taxpayer will have a basis in the asset. Taxpayer will then consume a portion of the asset year after year. Taxpayer may deduct such incremental consumption of a productive asset year after year. This deduction is for “depreciation” – whose name is now “cost recovery.” § 168. To the extent of the depreciation deduction, taxpayer has converted investment into consumption. Hence, taxpayer must reduce his/her/its basis in the asset for such deductions. § 1016. This represents “de-investment” in the asset.





4. Section 109 does not apply to improvements that the lessee makes which the parties intend as rent. Reg. § 1.61-8(c) (“If a lessee places improvements on real estate which constitute, in whole or in part, a substitute for rent, such improvements constitute rental income to the lessor.”)


• Suppose that a retailer leases space for a period of one year in taxpayer/lessor’s shopping mall. As part of the rental, lessee agrees to install various fixtures and to leave them to the lessor at the termination of the lease. The value of the fixtures is $20,000.


• What is lessor’s basis in the fixtures?


• Exactly what does the payment of rent purchase?


• Exactly what does a lessor “sell” by accepting a rent payment?


5. Consider each of the rules the Court considered – as well as the rule that Congress created in §§ 109/1019. Identify each rule and consider this question: what difference does it make which rule is applied?


• Let’s assume that the lessee did not remove a building, but simply erected a new building on the premises. Let’s also put some numbers and dates into the problem for illustrative purposes. Assume that the fmv of the building in 1990 upon completion is $400,000. The building will last 40 years. The building will lose $10,000 of value every year, and this is the amount that taxpayer may claim as a depreciation/cost recovery deduction. Taxpayer must reduce his/her basis in the property (§ 1016) for depreciation deductions. The adjusted basis of the property equals its fmv. The lease upon completion of the building will run another 20 years until 2010. The lessee did not default thereby causing early termination of the lease. Immediately upon termination of the lease, taxpayer sells the property, and the portion of the selling price attributable to the building is $200,000. Taxpayer pays income tax equal to 30% of his/her/its income from whatever taxable events occur.


(1) CIR’s view, the rule of the 1917 regulations, and the Supreme Court’s holding in Helvering v. Bruun: taxpayer derives taxable income at the termination of the lease equal to fmv − (ab in old building)


• How much gross income must taxpayer recognize for receiving the building and when?


• How much is the income tax on this item of taxpayer’s gross income?


• How much gain will taxpayer realize from the sale of the building?


• How much income tax must taxpayer pay for having sold the building?


• What is taxpayer’s total tax bill?


(2) Miller v. Gearin: taxpayer must recognize taxable income equal to the fmv of that improvement in the year of completion.


• How much gross income must taxpayer recognize for receiving the building and when?


• How much is the income tax on this item of taxpayer’s gross income?


• What will taxpayer’s basis in the building be?


• What will taxpayer’s annual depreciation/cost recovery allowance be for each of the next twenty years?


• How much will the annual depreciation/cost recovery allowance reduce taxpayer’s income tax liability for each of the remaining years of the lease?


• What will be the total reduction in taxpayer’s income tax liability resulting from depreciation/cost recovery allowances?


• What should happen to taxpayer’s basis in the building for each year that he/she/it claims a depreciation/cost recovery deduction?


• What will be taxpayer’s net income tax liability for having received the building?


• How much gain will taxpayer realize from the sale of the building?


• How much income tax must taxpayer pay for having sold the building?


• What is taxpayer’s total tax bill?


(3) New regulations that the Court referenced in Bruun that Treasury promulgated after Miller: taxpayer includes the discounted present value (PV) of the improvement’s fmv at the termination of lease in his/her/its taxable income at the time of completion of the building.


• How much gross income must taxpayer recognize for receiving the building and when?


• How much is the income tax on this item of taxpayer’s gross income?


• How much gain will taxpayer realize from the sale of the building?


• How much income tax must taxpayer pay for having sold the building?


• What is taxpayer’s total tax bill?


(4) Even newer regulations and the rule of the Court of Claims’s holding in M.E. Blatt Co. v. U.S.: taxpayer/lessor must determine what the fmv of the improvement will be at the termination of the lease and report as taxable income for each remaining year of the lease an aliquot share of that amount. In the event of premature termination, taxpayer/lessor must report as taxable income or may claim as a reduction to his/her taxable income an amount equal to (fmv at time of termination) − (amount of income previously taxed).


• How much gross income must taxpayer recognize for receiving the building and when?


• How much is the income tax on this item of taxpayer’s gross income?


• How much gain will taxpayer realize from the sale of the building?


• How much income tax must taxpayer pay for having sold the building?


• What is taxpayer’s total tax bill?


(5) §§ 109/1019, Hewitt Realty Co. v. CIR, and Supreme Court holding in M.E. Blatt Co. v. U.S.


• How much gross income must taxpayer recognize for receiving the building and when?


• How much is the income tax on this item of taxpayer’s gross income?


• How much gain will taxpayer realize from the sale of the building?


• How much income tax must taxpayer pay for having sold the building?


• What is taxpayer’s total tax bill?


Compare the tax liability of taxpayer in (1), (2), (3), (4), and (5). Did the choice of the applicable rule affect the net income tax liability of taxpayer?


6. It is very expensive to litigate a case to a federal circuit court of appeals or all the way to the United States Supreme Court. Apparently, the prevailing rule did not affect taxpayer’s net tax liability under the hypothetical facts laid down for this exercise. If the choice of rule does not alter the final tax liability of a taxpayer, why would parties spend serious money litigating a choice of rule question to the Supreme Court? For that matter, why would the Treasury Department use up so much ink promulgating and then changing regulations?


7. The answer (of course) lies in the fact that the right to have $1 today is worth more than the right to have $1 at some future time. The number of dollars involved in any of these transactions may not change, but their value certainly does. Yet calculations of taxable income and income tax liability do not (often) change merely because $1 today is worth more than $1 tomorrow. Taxpayers understand that principle very well and seek to reduce the present value of their tax liability as much as possible. They can do this by accelerating recognition of deductions and deferring recognition of income.


• We now consider exactly how taxpayers and the CIR would value the same tax liability that taxpayers must pay (and the U.S. Treasury would receive) sooner rather than later.


8. There are formulas that incorporate the variables of time and discount rate that enable us to determine either the future value (FV) of $1 now or the present value (PV) of $1 in the future. We can use the formulas to generate easy-to-use tables that enable us to make future value and present value determinations.


• You can Google “present value tables” to find a variety of such tables.


• Some tables appear in the pages immediately following this one. Do not forget that these tables are here. You may wish to use them from time to time.


Table 1 shows what $1 today will be worth at given interest rates (across the top of the table) after a given number of years (down the left hand side of the table).


Table 2 shows what $1 at some given future date is worth today.


Table 3 shows the present value of receiving $1 at the end of every year for a given number of years. This of course is an annuity, but this table is very useful in determining the PV of any stream of payments that does not vary in amount, e.g., depreciation deductions.


• A useful approximation that you can verify by referring to table 1 is the so-called rule of 72. Simply divide 72 by the interest rate expressed as a whole number. The quotient is very close to the length of time it takes money to double in value at that interest rate.


Table 1: Future value of $1 at various interest rates, compounded annually:


FV = 1(1 + r)t


FV = future value; r = interest rate expressed as decimal; t = time, i.e., # of years. In the left hand column is the number of years. In the top row is the interest rate.



1% 2% 3% 4% 5%
1 1.01 1.02 1.03 1.04 1.05
2 1.0201 1.0404 1.0609 1.0816 1.1025
3 1.0303 1.0612 1.0927 1.1249 1.1576
4 1.0406 1.0824 1.1255 1.1699 1.2155
5 1.051 1.1041 1.1593 1.2167 1.2763
6 1.0615 1.1262 1.1941 1.2653 1.3401
7 1.0721 1.1487 1.2299 1.3159 1.4071
8 1.0829 1.1717 1.2668 1.3686 1.4775
9 1.0937 1.1951 1.3048 1.4233 1.5513
10 1.1046 1.219 1.3439 1.4802 1.6289
20 1.2202 1.4859 1.8061 2.1911 2.6533
30 1.3478 1.8114 2.4273 3.2434 4.3219


6% 7% 8% 9% 10%
1 1.06 1.07 1.08 1.09 1.1
2 1.1236 1.1449 1.1664 1.1881 1.21
3 1.191 1.225 1.2597 1.295 1.331
4 1.2625 1.3108 1.3605 1.4116 1.4641
5 1.3382 1.4026 1.4693 1.5386 1.6105
6 1.4185 1.5007 1.5869 1.6771 1.7716
7 1.5036 1.6058 1.7138 1.828 1.9487
8 1.5938 1.7182 1.8509 1.9926 2.1436
9 1.6895 1.8385 1.999 2.1719 2.3579
10 1.7908 1.9672 2.1589 2.3674 2.5937
20 3.2071 3.8697 4.661 5.6044 6.7275
30 5.7435 7.6123 10.063 13.268 17.449
Table 2: Present Value of $1 at a future date at a given interest rate compounded annually:


PV = 1/(1 + r)t



1% 2% 3% 4% 5%
1 0.9901 0.9804 0.9709 0.9615 0.9524
2 0.9803 0.9612 0.9426 0.9246 0.907
3 0.9706 0.9423 0.9151 0.889 0.8638
4 0.961 0.9238 0.8885 0.8548 0.8227
5 0.9515 0.9057 0.8626 0.8219 0.7835
6 0.942 0.888 0.8375 0.7903 0.7462
7 0.9327 0.8706 0.8131 0.7599 0.7107
8 0.9235 0.8535 0.7894 0.7307 0.6768
9 0.9143 0.8368 0.7664 0.7026 0.6446
10 0.9053 0.8203 0.7441 0.6756 0.6139
20 0.8195 0.673 0.5537 0.4564 0.3769
30 0.7419 0.5521 0.412 0.3083 0.2314


6% 7% 8% 9% 10%
1 0.9434 0.9346 0.9259 0.9174 0.9091
2 0.89 0.8734 0.8573 0.8417 0.8264
3 0.8396 0.8163 0.7938 0.7722 0.7513
4 0.7921 0.7629 0.735 0.7084 0.683
5 0.7473 0.713 0.6806 0.6499 0.6209
6 0.705 0.6663 0.6302 0.5963 0.5645
7 0.6651 0.6227 0.5835 0.547 0.5132
8 0.6274 0.582 0.5403 0.5019 0.4665
9 0.5919 0.5439 0.5002 0.4604 0.4241
10 0.5584 0.5083 0.4632 0.4224 0.3855
20 0.3118 0.2584 0.2145 0.1784 0.1486
30 0.1741 0.1314 0.0994 0.0754 0.0573
Table 3: Present Value of a $1 Annuity Discounted by a Given Interest rate for a Certain Number of Annual Payments:


PV = (-0.1)*(1-1/(1 + i)-t))/i



1% 2% 3% 4% 5%
1 0.9901 0.9804 0.9709 0.9615 0.9524
2 1.9704 1.9416 1.9135 1.8861 1.8594
3 2.941 2.8839 2.8286 2.7751 2.7232
4 3.902 3.8077 3.7171 3.6299 3.546
5 4.8534 4.7135 4.5797 4.4518 4.3295
6 5.7955 5.6014 5.4172 5.2421 5.0757
7 6.7282 6.472 6.2303 6.0021 5.7864
8 7.6517 7.3255 7.0197 6.7327 6.4632
9 8.566 8.1622 7.7861 7.4353 7.1078
10 9.4713 8.9826 8.5302 8.1109 7.7217
20 18.046 16.351 14.877 13.59 12.462
30 25.808 22.396 19.6 17.292 15.372


6% 7% 8% 9% 10%
1 0.9434 0.9346 0.9259 0.9174 0.9091
2 1.8334 1.808 1.7833 1.7591 1.7355
3 2.673 2.6243 2.5771 2.5313 2.4869
4 3.4651 3.3872 3.3121 3.2397 3.1699
5 4.2124 4.1002 3.9927 3.8897 3.7908
6 4.9173 4.7665 4.6229 4.4859 4.3553
7 5.5824 5.3893 5.2064 5.033 4.8684
8 6.2098 5.9713 5.7466 5.5348 5.3349
9 6.8017 6.5152 6.2469 5.9952 5.759
10 7.3601 7.0236 6.7101 6.4177 6.1446
20 11.47 10.594 9.8181 9.1285 8.5136
30 13.765 12.409 11.258 10.274 9.4269

9. Now: let’s assume that the discount rate in our problems above is 8% and rework the answers. Compare the present value of taxpayer’s $60,000 tax liability on the very same transactions in 1990 under each of the five rules:


(1) CIR’s view, the of the 1917 regulations, and the Supreme Court’s holding in Bruun: taxpayer derives taxable income at the termination of the lease equal to fmv − (ab in old building).


• In 1990, what is the present value of taxpayer’s net tax liability?


(2) Miller v. Gearin: taxpayer must recognize taxable income equal to the fmv of that improvement in the year of completion.


• In 1990, what is the present value of taxpayer’s net tax liability?


(3) New regulations that the Court referenced in Bruun that Treasury promulgated after Miller: the discounted PV of improvement’s fmv at the termination of lease is included in taxpayer’s taxable income at the time of completion of the building.


• In 1990, what is the present value of taxpayer’s net tax liability?


(4) Even newer regulations and the rule of the Court of Claims’s holding in M.E. Blatt Co. v. U.S.: taxpayer/lessor must determine what the fmv of the improvement will be at the termination of the lease and report as taxable income for each remaining year of the lease an aliquot share of that depreciated amount. In the event of premature termination, taxpayer/lessor must report as taxable income or may claim as a reduction to his/her taxable income an amount equal to (fmv at time of termination) − (amount of income previously taxed).


• In 1990, what is the present value of taxpayer’s net tax liability?


(5) §§ 109/1019, Hewitt Realty Co. v. CIR, and Supreme Court holding in M.E. Blatt Co. v. U.S.


• In 1990, what is the present value of taxpayer’s net tax liability?


10. The time value of money is one place where taxpayers and the Commissioner now play the tax game. Look for the ways in which it affects the contentions of parties in the cases ahead. The higher the discount rate, the more taxpayer benefits from deferring payment of a tax and/or accelerating a deduction.


11. Congress can itself exploit the time value of money to pursue certain policy objectives that require taxpayers to save money in order that they make a particular consumption choice. For example, Congress may wish for taxpayers to save money throughout their working lives that they can spend in retirement. Sections 219/62(a)(7) permit taxpayers to reduce their adjusted gross income (AGI) by amounts that they save in an Individual Retirement Account (IRA). So also, Congress may wish for taxpayers to save money that they can spend on medical expenses at some future date. Sections 223/62(a)(19) permit taxpayers to reduce their (AGI) by amounts that they save in a Health Savings Account. The money that taxpayers deposit in these accounts at a young age can grow significantly, as the tables above attest.


E. Imputed Income



Consider the following:


Mary and John are attorneys who both are in the 25% marginal tax bracket. They are equally productive and efficient in their work as attorneys. They both own houses that need a paint job. The cost of hiring a painter to paint their homes is $9000.


• John hires a painter to paint his house. In order to pay the painter, John must work six extra weekends in order to earn another $12,000. After paying $3000 in taxes, John can then pay the painter $9000. For having worked to earn an additional $12,000 and paid $3000 more in income tax, John will have a house with a $9000 paint job – which he will commence “consuming.” John had to pay $3000 in income taxes in order to consume $9000.


• Mary decides to do the job herself on five successive weekends. The fmv of these services is $9000. When she has completed the job, Mary will have a house with a $9000 paint job – which she will commence “consuming.” Mary paid nothing in income taxes in order to consume $9000.


Notice: John was able to earn $2000 per weekend. Mary “earned” $1800 per weekend. Mary is not as productive or as efficient a painter as she is an attorney. (Otherwise she should give up practicing law and take up house painting.) Nevertheless, Mary expended fewer resources in order to acquire a painted house than John did. How?


• The answer lies in the fact that John had to pay income tax on his “consumption,” and Mary did not.


• Services that one performs for oneself give rise to “imputed income.”


• As a matter of administrative practice and convenience, we do not tax imputed income.


• As the facts of this hypothetical illustrate, not taxing imputed income causes inefficiency. Mary would create more value by practicing law on the weekends than by painting.


• Not taxing imputed income also causes distortions because from Mary’s point of view, not taxing her imputed income encourages her to perform more services for herself – so long as the cost of her inefficiency is less than the income taxes that she saves.


• In addition to these inefficiencies and distortions, not taxing imputed income derived from performing services for oneself costs the U.S. Treasury money. Obviously, we should not be concerned about de minimis amounts, e.g., mowing our own lawns. But one major source of lost revenue is the non-taxation of imputed income derived by the stay-at-home parent.


Eileen and Robert are both in the 25% tax bracket. Assume that the annual rental rate for a home is 10% of the home’s fmv. Both Robert and Eileen have accumulated $250,000. The income necessary to accumulate this money has already been subject to income tax. Prevailing interest rates are 8%.


• Robert elects to take the $20,000 return on his investments to pay the rent on a house valued at $150,000. After paying $5000 in income taxes, he will have $15,000 with which to pay rent. His investment will not grow because he uses his entire return on investment to pay income tax plus rent.


• Eileen elects to change the form in which she holds some of her investment and to use $150,000 to purchase a house. She will still have $100,000 invested. Eileen can live in her house rent-free and will earn a 6% (i.e., 8% − (25% of 8%)) after-tax return on her investment, compounded annually. See table 1 in the discussion of Bruun, supra. In less than 16 years, Eileen will have $250,000 PLUS she will own a $150,000 home (assuming that it does not lose value; in fact its value might increase).


Notice: Obviously Eileen came out ahead of Robert. Both Eileen and Robert started with the same wealth and lived in the same type of house. How did Eileen do so much better than Robert?


• Again, Robert had to pay income tax on his consumption while Eileen did not.


• The fair rental value of property that a taxpayer owns is also imputed income, and it is not subject to income tax.


• As the facts of this hypothetical illustrate, not taxing imputed income causes inefficiency because it encourages taxpayers to invest in a certain type of asset in preference to other investments only because of certain characteristics of the property.


• In the not-so-distant past, the fmv of a house did not usually decline.


• A house is something that a consumer can and wants to consume.


• Not taxing imputed income derived from ownership of property increases a taxpayer’s return on investing in such property. Eileen received $15,000 worth of rent annually on her $150,000 investment – a tax-free return of 10%. A net after-tax return of 10% subject to 25% income tax would require a before-tax return of 13.33%.


• A major source of lost revenue to the Treasury through the non-taxation of the fair rental value of property that taxpayer owns results from Americans’ widespread ownership of homes – and the ownership of homes that are more expensive than what many taxpayers would otherwise purchase.


• Perhaps the risk-adjusted return on Turkish apricot futures is greater than the 10% return Eileen so easily consumed on her investments, but Eileen will not choose to maximize her investment return in this manner unless the return on such an investment is greater than 13.33%. The Tax Code assures that many taxpayers will prefer to purchase assets such as homes rather than make investments with higher before-tax returns.


• In the event that not imputing the fair rental value of property to its owner as taxable income is not sufficient incentive to invest in homes –


• § 163(h) permits deduction of mortgage interest on up to $1,000,000 of indebtedness incurred to purchase a home or of interest on up to $100,000 of home equity indebtedness.


• § 121 permits exclusion from gross income of up to $250,000 of gain from the sale or exchange of a taxpayer’s principal residence under prescribed circumstances.


• § 164(a)(1) permits a deduction for state and local, and foreign real property taxes.39



• Of course, these rules greatly increase demand for houses. Without question, the Tax Code has distorted the market for houses and increased their fmv.


Now consider whether taxpayer realizes less gross income upon receipt of a benefit for which his employer paid cash when he foregoes the opportunity to earn imputed income.


Problem: Taxpayer Koons entered into a contract of employment with Aerojet General Corporation (Aerojet) to work at its plant near Sacramento, California. Aerojet agreed to pay taxpayer’s travel and moving expenses of Koons to move himself and his family from Big Springs, Texas to Sacramento. This included the cost of hiring a moving company to move his furniture and belongings. Aerojet reimbursed Koons for his payment to the movers, whose charges were no more than their fmv. In 1959, there was no deduction or exclusion for this expenditure (see §§ 217, 132(a)(6), 62(a)(15)), so Koons had to include Aerojet’s reimbursement in his gross income. Koons paid the income tax on the reimbursement and sued for a refund. At trial, he offered to show that the value to him of hiring a moving company was much less than its cost. He also offered to show that had he known that the cost of moving was taxable income, he would have rented a trailer and done most of the work himself. He had done this on five other occasions. Koons argued that he should include in his gross income only the rental cost of a trailer.


• Should a trial court judge sustain the United States’s objections to his offer of proof as irrelevant?


• Must taxpayer Koons include in his gross income the fmv of the services rendered, or some lesser amount?


See Koons v. United States, 315 F.2d 542 (1963).


• How well does the argument “I could have done it myself for a lot less money” square with the tax rules governing imputed income? – with SHS?


III. The Constitutional and Statutory Definitions of “Gross Income:” Realization



Can a taxpayer realize income if s/he never receives it, but someone else does?


Helvering v. Horst, 311 U.S. 112 (1940)



MR. JUSTICE STONE delivered the opinion of the Court.


The sole question for decision is whether the gift, during the donor’s taxable year, of interest coupons detached from the bonds, delivered to the donee and later in the year paid at maturity, is the realization of income taxable to the donor.


In 1934 and 1935, respondent, the owner of negotiable bonds, detached from them negotiable interest coupons shortly before their due date and delivered them as a gift to his son, who, in the same year, collected them at maturity. The Commissioner ruled that, under … [§ 61], the interest payments were taxable, in the years when paid, to the respondent donor, who reported his income on the cash receipts basis. The circuit court of appeals reversed the order of the Board of Tax Appeals sustaining the tax. We granted certiorari because of the importance of the question in the administration of the revenue laws and because of an asserted conflict in principle of the decision below with that of Lucas v. Earl, 281 U.S. 111, and with that of decisions by other circuit courts of appeals. See Bishop v. Commissioner, 54 F.2d 298; Dickey v. Burnet, 56 F.2d 917, 921; Van Meter v. Commissioner, 61 F.2d 817.


The court below thought that, as the consideration for the coupons had passed to the obligor, the donor had, by the gift, parted with all control over them and their payment, and for that reason the case was distinguishable from Lucas v. Earl, supra, and Burnet v. Leininger, 285 U.S. 136, where the assignment of compensation for services had preceded the rendition of the services, and where the income was held taxable to the donor.


The holder of a coupon bond is the owner of two independent and separable kinds of right. One is the right to demand and receive at maturity the principal amount of the bond representing capital investment. The other is the right to demand and receive interim payments of interest on the investment in the amounts and on the dates specified by the coupons. Together, they are an obligation to pay principal and interest given in exchange for money or property which was presumably the consideration for the obligation of the bond. Here respondent, as owner of the bonds, had acquired the legal right to demand payment at maturity of the interest specified by the coupons and the power to command its payment to others which constituted an economic gain to him.


Admittedly not all economic gain of the taxpayer is taxable income. From the beginning, the revenue laws have been interpreted as defining “realization” of income as the taxable event, rather than the acquisition of the right to receive it. And “realization” is not deemed to occur until the income is paid. But the decisions and regulations have consistently recognized that receipt in cash or property is not the only characteristic of realization of income to a taxpayer on the cash receipts basis. Where the taxpayer does not receive payment of income in money or property, realization may occur when the last step is taken by which he obtains the fruition of the economic gain which has already accrued to him. Old Colony Trust Co. v. Commissioner, 279 U.S. 716; Corliss v. Bowers, 281 U.S. 376, 378. Cf. Burnet v. Wells, 289 U.S. 670.


In the ordinary case the taxpayer who acquires the right to receive income is taxed when he receives it, regardless of the time when his right to receive payment accrued. But the rule that income is not taxable until realized has never been taken to mean that the taxpayer, even on the cash receipts basis, who has fully enjoyed the benefit of the economic gain represented by his right to receive income can escape taxation because he has not himself received payment of it from his obligor. The rule, founded on administrative convenience, is only one of postponement of the tax to the final event of enjoyment of the income, usually the receipt of it by the taxpayer, and not one of exemption from taxation where the enjoyment is consummated by some event other than the taxpayer’s personal receipt of money or property. [citation omitted] This may occur when he has made such use or disposition of his power to receive or control the income as to procure in its place other satisfactions which are of economic worth. The question here is whether, because one who in fact receives payment for services or interest payments is taxable only on his receipt of the payments, he can escape all tax by giving away his right to income in advance of payment. If the taxpayer procures payment directly to his creditors of the items of interest or earnings due him, see Old Colony Trust Co. v. Commissioner, supra; [citations omitted], or if he sets up a revocable trust with income payable to the objects of his bounty, [citation omitted], [citations omitted], he does not escape taxation because he did not actually receive the money. [citations omitted]


Underlying the reasoning in these cases is the thought that income is “realized” by the assignor because he, who owns or controls the source of the income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants. The taxpayer has equally enjoyed the fruits of his labor or investment and obtained the satisfaction of his desires whether he collects and uses the income to procure those satisfactions or whether he disposes of his right to collect it as the means of procuring them. [citation omitted]


Although the donor here, by the transfer of the coupons, has precluded any possibility of his collecting them himself, he has nevertheless, by his act, procured payment of the interest, as a valuable gift to a member of his family. Such a use of his economic gain, the right to receive income, to procure a satisfaction which can be obtained only by the expenditure of money or property would seem to be the enjoyment of the income whether the satisfaction is the purchase of goods at the corner grocery, the payment of his debt there, or such nonmaterial satisfactions as may result from the payment of a campaign or community chest contribution, or a gift to his favorite son. Even though he never receives the money, he derives money’s worth from the disposition of the coupons which he has used as money or money’s worth in the procuring of a satisfaction which is procurable only by the expenditure of money or money’s worth. The enjoyment of the economic benefit accruing to him by virtue of his acquisition of the coupons is realized as completely as it would have been if he had collected the interest in dollars and expended them for any of the purposes named. [citation omitted]


In a real sense, he has enjoyed compensation for money loaned or services rendered, and not any the less so because it is his only reward for them. To say that one who has made a gift thus derived from interest or earnings paid to his donee has never enjoyed or realized the fruits of his investment or labor because he has assigned them instead of collecting them himself and then paying them over to the donee is to affront common understanding and to deny the facts of common experience. Common understanding and experience are the touchstones for the interpretation of the revenue laws.


The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment, and hence the realization, of the income by him who exercises it. We have had no difficulty in applying that proposition where the assignment preceded the rendition of the services, Lucas v. Earl, supra; Burnet v. Leininger, supra, for it was recognized in the Leininger case that, in such a case, the rendition of the service by the assignor was the means by which the income was controlled by the donor, and of making his assignment effective. But it is the assignment by which the disposition of income is controlled when the service precedes the assignment, and, in both cases, it is the exercise of the power of disposition of the interest or compensation, with the resulting payment to the donee, which is the enjoyment by the donor of income derived from them.




The dominant purpose of the revenue laws is the taxation of income to those who earn or otherwise create the right to receive it and enjoy the benefit of it when paid. See Corliss v. Bowers, supra, 281 U.S. 376, 378; Burnet v. Guggenheim, 288 U.S. 280, 283. The tax laid by the 1934 Revenue Act upon income “derived from … wages, or compensation for personal service, of whatever kind and in whatever form paid … ; also from interest …” therefore cannot fairly be interpreted as not applying to income derived from interest or compensation when he who is entitled to receive it makes use of his power to dispose of it in procuring satisfactions which he would otherwise procure only by the use of the money when received.


It is the statute which taxes the income to the donor although paid to his donee. Lucas v. Earl, supra; Burnet v. Leininger, supra. True, in those cases, the service which created the right to income followed the assignment, and it was arguable that, in point of legal theory, the right to the compensation vested instantaneously in the assignor when paid, although he never received it, while here, the right of the assignor to receive the income antedated the assignment which transferred the right, and thus precluded such an instantaneous vesting. But the statute affords no basis for such “attenuated subtleties.” The distinction was explicitly rejected as the basis of decision in Lucas v. Earl. It should be rejected here, for no more than in the Earl case can the purpose of the statute to tax the income to him who earns or creates and enjoys it be escaped by “anticipatory arrangements … however skilfully devised” to prevent the income from vesting even for a second in the donor.


Nor is it perceived that there is any adequate basis for distinguishing between the gift of interest coupons here and a gift of salary or commissions. The owner of a negotiable bond and of the investment which it represents, if not the lender, stands in the place of the lender. When, by the gift of the coupons, he has separated his right to interest payments from his investment and procured the payment of the interest to his donee, he has enjoyed the economic benefits of the income in the same manner and to the same extent as though the transfer were of earnings, and, in both cases, the import of the statute is that the fruit is not to be attributed to a different tree from that on which it grew. See Lucas v. Earl, supra, 281 U.S. at 115.




The separate opinion of MR. JUSTICE McREYNOLDS.




The unmatured coupons given to the son were independent negotiable instruments, complete in themselves. Through the gift, they became at once the absolute property of the donee, free from the donor’s control and in no way dependent upon ownership of the bonds. No question of actual fraud or purpose to defraud the revenue is presented.




… The challenged judgment should be affirmed.


THE CHIEF JUSTICE and MR. JUSTICE ROBERTS concur in this opinion.


Notes and Questions:


1. Under the rules of § 102, donors make gifts with after-tax income, and the donee may exclude the value of the gift from his/her gross income. Taxpayer Horst of course tried to reverse this.


2. No doubt, taxpayer’s son was in a lower tax bracket than taxpayer was. Hence, the dividends would have been subject to a lower rate of tax if taxpayer had prevailed.


3. Consumption can take the form of directing income to another.


4. The Internal Revenue Code taxes “taxable income,” §§ 1(a-e). The computation of “taxable income” begins with a summing up of all items of “gross income.” The concept of “gross income” does not inherently embody a netting of gains and losses. A taxpayer may deduct losses only to the extent that the Code permits.40 Sections 165(a and c) allow taxpayers to deduct trade or business losses and investment losses. A realization requirement applies to deductions, just as it does to gross income. To be deductible, taxpayer must have “realized” the losses. Now read Cottage Savings Association.



Cottage Savings Ass’n v. CIR, 499 U.S. 554 (1991)



JUSTICE MARSHALL delivered the opinion of the Court.


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.




Petitioner Cottage Savings Association (Cottage Savings) is a savings and loan association (S & L) formerly regulated by the Federal Home Loan Bank Board (FHLBB). 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. 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.


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.41 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.



This case involves a typical Memorandum R-49 transaction. On December 31, 1980, Cottage Savings sold “90% participation” in 252 mortgages to four S & L’s. It simultaneously purchased “90% participation interests” in 305 mortgages held by these S & L’s.42 All of the loans involved 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.



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 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.


On appeal by the Commissioner, the Court of Appeals reversed. The Court of Appeals agreed with the Tax Court’s determination that Cottage Savings had realized its losses through the transaction. 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).


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, we granted certiorari. We now reverse.




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 “[t]he 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. [citation omitted]. 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 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 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 does, we must further decide what that requirement amounts to and how it applies in this case. We consider these questions in turn.




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 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).


We conclude that Treasury Regulation § 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. And since 1934, the Commissioner has construed the statutory term “disposition of property” to include a “material difference” requirement. 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).


Treasury Regulation § 1.1001-1 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 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) (recognizing realization requirement). Because these decisions were part of the “contemporary legal context” in which Congress enacted § 202(a) of the 1924 Act, [citation omitted], 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) [citations omitted]. The Commissioner’s construction of the statutory language to incorporate these principles certainly was reasonable.




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 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 exchanges satisfy this requirement. 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). [citation omitted].


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. We reasoned that the stock dividend merely reflected the increased worth of the taxpayer’s stock, and that a taxpayer realizes increased worth of property only by receiving “something of exchangeable value proceeding from the property,” see 252 U.S. 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 that had appreciated in value since its acquisition. 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 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 different” from what they previously had. United States v. Phellis, 257 U.S. at 169-173; see Marr v. United States, supra, 268 U.S. 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 theretofore had.” Weiss v. Stearn, supra. 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, 268 U.S. 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, Phellis, Marr, and Weiss stand for the principle that properties are “different” in the 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, 257 U.S. at 173, or if they confer “differen[t] rights and powers” in the same corporation, Marr v. United States, supra, 268 U.S. 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 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 whether there is a regulatory agency whose views should be taken into account, and then assess how the relevant market 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 of his test.


Finally, the Commissioner’s test is incompatible with the structure of the Code. Section 1001(c) … 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.




Under our interpretation of § 1001(a), an exchange of property gives rise to a realization event so long as the exchanged 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 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 a realization event, regardless of the status of the mortgages under the criteria of Memorandum R-49.




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). …


The Commissioner offers a minimal defense of the Court of Appeals’ conclusion. …


… In view of the Commissioner’s failure 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).




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.




Consistency between tax and financial accounting: The FHLBB obviously intended Memorandum R-49 to enable savings and loan associations to reduce their income tax liability and thereby come closer to solvency. Of course this effort came at the expense of all other taxpayers who must “pick up the slack.”


• Income tax rules often require taxpayers to maintain consistent positions with regard to financial accounting and tax accounting. On the authority of the FHLBB – not Congress or the IRS – the savings and loan associations could treat dud loans completely differently for financial accounting and tax accounting purposes.





JUSTICE BLACKMUN, with whom JUSTICE WHITE joins, concurring in part and dissenting in part – omitted.


Notes and Questions:


1. As a practical matter, what was wrong with the Commissioner’s arguments?


2. What is the test of “realization” that the Court derived from Phellis/Weiss/Marr?


3. In considering its earlier constructions of the “realization” requirement (part IIB of the opinion) in Macomber/Phellis/Weiss/Marr, the Court never mentioned the Sixteenth Amendment. Moreover, the Court stated in part IIB that administrative purposes underlie the “realization requirement.” By this time – if not earlier – the Court had de-constitutionalized the “realization” requirement – a matter that is critical to the Subpart F rules governing U.S. taxation of foreign source income.


4. The Court’s application of the realization requirement would seem to give taxpayers considerable control over the timing of tax gains and losses.


IV. The Constitutional and Statutory Definitions of “Gross Income:” Dominion and Control



Basically, taxpayer has dominion and control over a monetary accession to wealth if, as a practical matter, s/he may spend it. The so-called “claim of right” doctrine – which the Court first announced in North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932) – implements this principle.




Claim of Right doctrine: Taxpayer must include in his/her gross income an item when s/he has a “claim of right” to it. In North American Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932), the Supreme Court stated the doctrine thus:


If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.





Gilbert v. Commissioner, 552 F.2d 478 (CA2 1977)



LUMBARD, Circuit Judge:


The taxpayer Edward M. Gilbert appeals from a determination by the tax court that he realized taxable income on certain unauthorized withdrawals of corporate funds made by him in 1962. We reverse.


Until June 12, 1962, Gilbert was president, principal stockholder, and a director of the E. L. Bruce Company, Inc., a New York corporation which was engaged in the lumber supply business. In 1961 and early 1962 Gilbert acquired on margin substantial personal and beneficial ownership of stock in another lumber supply company, the Celotex Corporation, intending ultimately to bring about a merger of Celotex into Bruce. To this end, he persuaded associates of his to purchase Celotex stock, guaranteeing them against loss, and also induced Bruce itself to purchase a substantial number of Celotex shares. In addition, on March 5, 1962, Gilbert granted Bruce an option to purchase his Celotex shares from him at cost. By the end of May 1962, 56% of Celotex was thus controlled by Gilbert and Bruce, and negotiations for the merger were proceeding; agreement had been reached that three of the directors of Bruce would be placed on the board of Celotex. It is undisputed that this merger would have been in Bruce’s interest.43



The stock market declined on May 28, 1962, however, and Gilbert was called upon to furnish additional margin for the Celotex shares purchased by him and his associates. Lacking sufficient cash of his own to meet this margin call, Gilbert instructed the secretary of Bruce to use corporate funds to supply the necessary margin. Between May 28 and June 6 a series of checks totalling $1,958,000 were withdrawn from Bruce’s accounts and used to meet the margin call. $5,000 was repayed to Bruce on June 5. According to his testimony in the tax court, Gilbert from the outset intended to repay all the money and at all times thought he was acting in the corporation’s best interests as well as his own.44 He promptly informed several other Bruce officers and directors of the withdrawals; however, some were not notified until June 11 or 12.



On about June 1, Gilbert returned to New York from Nevada, where he had been attending to a personal matter. Shortly thereafter he consulted with Shearman, Sterling & Wright, who were outside counsel to Bruce at the time, regarding the withdrawals. They, he, and another Bruce director initiated negotiations to sell many of the Celotex shares to Ruberoid Company as a way of recouping most of Bruce’s outlay.


On June 8, Gilbert went to the law offices of Shearman, Sterling & Wright and executed interest-bearing promissory notes to Bruce for $1,953,000 secured by an assignment of most of his property. [(footnote omitted)]. The notes were callable by Bruce on demand, with presentment and notice of demand waived by Gilbert. The tax court found that up through June 12 the net value of the assets assigned for security by Gilbert substantially exceeded the amount owed. [(footnote omitted)].


After Gilbert informed other members of the Bruce board of directors of his actions, a meeting of the board was scheduled for the morning of June 12. At the meeting the board accepted the note and assignment but refused to ratify Gilbert’s unauthorized withdrawals. During the meeting, word came that the board of directors of the Ruberoid Company had rejected the price offered for sale of the Celotex stock. Thereupon, the Bruce board demanded and received Gilbert’s resignation and decided to issue a public announcement the next day regarding his unauthorized withdrawals. All further attempts on June 12 to arrange a sale of the Celotex stock fell through and in the evening Gilbert flew to Brazil, where he stayed for several months. On June 13 the market price of Bruce and Celotex stock plummeted, and trading in those shares was suspended by the Securities and Exchanges Commission.


On June 22 the Internal Revenue Service filed tax liens against Gilbert based on a jeopardy assessment for $3,340,000, of which $1,620,000 was for 1958-1960 and $1,720,000 was for 1962. [(footnote omitted)]. Bruce, having failed to file the assignment from Gilbert because of the real estate filing fee involved,45 now found itself subordinate in priority to the IRS and, impeded by the tax lien, has never since been able to recover much of its $1,953,000 from the assigned assets.46 For the fiscal year ending June 30, 1962, Bruce claimed a loss deduction on the $1,953,000 withdrawn by Gilbert. Several years later Gilbert pled guilty to federal and state charges of having unlawfully withdrawn the funds from Bruce.



On these facts, the tax court determined that Gilbert realized income when he made the unauthorized withdrawals of funds from Bruce, and that his efforts at restitution did not entitle him to any offset against this income.


The starting point for analysis of this case is James v. United States, 366 U.S. 213 (1961), which established that embezzled funds can constitute taxable income to the embezzler.


When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, “he has received income which he is required to return, even though it may still be claimed that he is not entitled to the money, and even though he may still be adjudged liable to restore its equivalent.” Id. at 219 [(quoting North American Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932)].


The Commissioner contends that there can never be “consensual recognition … of an obligation to repay” in an embezzlement case. He reasons that because the corporation as represented by a majority of the board of directors was unaware of the withdrawals, there cannot have been consensual recognition of the obligation to repay at the time the taxpayer Gilbert acquired the funds. Since the withdrawals were not authorized and the directors refused to treat them as a loan to Gilbert, the Commissioner concludes that Gilbert should be taxed like a thief rather than a borrower.


In a typical embezzlement, the embezzler intends at the outset to abscond with the funds. If he repays the money during the same taxable year, he will not be taxed. See James v. Commissioner, supra at 220; Quinn v. Commissioner, 524 F.2d 617, 624-25 (7th Cir. 1975); Rev. Rul. 65-254, 1965 2 Cum. Bul. 50. As we held in Buff v. Commissioner, 496 F.2d 847 (2d Cir. 1974), if he spends the loot instead of repaying, he cannot avoid tax on his embezzlement income simply by signing promissory notes later in the same year. See also id. at 849-50 (Oakes, J., concurring).


This is not a typical embezzlement case, however, and we do not interpret James as requiring income realization in every case of unlawful withdrawals by a taxpayer. There are a number of facts that differentiate this case from Buff and James. When Gilbert withdrew the corporate funds, he recognized his obligation to repay and intended to do so.47 The funds were to be used not only for his benefit but also for the benefit of the corporation; meeting the margin calls was necessary to maintain the possibility of the highly favorable merger. Although Gilbert undoubtedly realized that he lacked the necessary authorization, he thought he was serving the best interests of the corporation and he expected his decision to be ratified shortly thereafter. That Gilbert at no time intended to retain the corporation’s funds is clear from his actions.48 He immediately informed several of the corporation’s officers and directors, and he made a complete accounting to all of them within two weeks. He also disclosed his actions to the corporation’s outside counsel, a reputable law firm, and followed its instructions regarding repayment. In signing immediately payable promissory notes secured by most of his assets, Gilbert’s clear intent was to ensure that Bruce would obtain full restitution. In addition, he attempted to sell his shares of Celotex stock in order to raise cash to pay Bruce back immediately.



When Gilbert executed the assignment to Bruce of his assets on June 8 and when this assignment for security was accepted by the Bruce board on June 12, the net market value of these assets was substantially more than the amount owed. The Bruce board did not release Gilbert from his underlying obligation to repay, but the assignment was nonetheless valid and Bruce’s failure to make an appropriate filing to protect itself against the claims of third parties, such as the IRS, did not relieve Gilbert of the binding effect of the assignment. Since the assignment secured an immediate payable note, Gilbert had as of June 12 granted Bruce full discretion to liquidate any of his assets in order to recoup on the $1,953,000 withdrawal. Thus, Gilbert’s net accretion in real wealth on the overall transaction was zero: he had for his own use withdrawn $1,953,000 in corporate funds but he had now granted the corporation control over at least $1,953,000 worth of his assets.


We conclude that where a taxpayer withdraws funds from a corporation which he fully intends to repay and which he expects with reasonable certainty he will be able to repay, where he believes that his withdrawals will be approved by the corporation, and where he makes a prompt assignment of assets sufficient to secure the amount owed, he does not realize income on the withdrawals under the James test. When Gilbert acquired the money, there was an express consensual recognition of his obligation to repay: the secretary of the corporation, who signed the checks, the officers and directors to whom Gilbert gave contemporaneous notification, and Gilbert himself were all aware that the transaction was in the nature of a loan. Moreover, the funds were certainly not received by Gilbert “without restriction as to their disposition” as is required for taxability under James; the money was to be used solely for the temporary purpose of meeting certain margin calls and it was so used. For these reasons, we reverse the decision of the tax court.


Notes and Questions:


1. James v. United States, 366 U.S. 213 (1961) was an embezzlement case. The Supreme Court had held in Commissioner v. Wilcox, 327 U.S. 404 (1946) that an embezzler did not realize gross income because he was subject to an obligation to repay the embezzled funds. Taxpayer had no bona fide claim of right to the funds. Id. at 408. In Rutkin v. United States, 343 U.S. 130, 139 (1952), the Supreme Court held that taxpayer must include money that he obtained by extortion in his gross income. James shifted the focus of such cases from the bona fides of a claim of right to consensual recognition of an obligation to repay. Gilbert turned on whether there was a consensual recognition of an obligation to repay.




Security and damage deposits: An electric utility company (IPL) requires customers with suspect credit to make a security deposit in order to assure prompt payment of utility bills. Customers are entitled to a refund of their deposit upon establishing good credit or making sufficient timely payments. The electric company treated the deposits as a current liability. So long as the company refunded the deposits when customers were entitled to them, the company could spend the money as it chose. Should the utility include the deposits in its gross income? The answer to this question turns on whether the company had “complete dominion” over the funds.


IPL hardly enjoyed ‘complete dominion’ over the customer deposits entrusted to it. Rather, these deposits were acquired subject to an express ‘obligation to repay,’ either at the time service was terminated or at the time a customer established good credit. So long as the customer fulfills his legal obligation to make timely payments, his deposit ultimately is to be refunded, and both the timing and method of that refund are largely within the control of the customer.”


… In determining whether a taxpayer enjoys ‘complete dominion’ over a given sum, the crucial point is not whether his use of the funds is unconstrained during some interim period. The key is whether the taxpayer has some guarantee that he will be allowed to keep the money. IPL’s receipt of these deposits was accompanied by no such guarantee.


CIR v. Indianapolis Power & Light Co., 493, 203, 209-10 (1990). What facts do you think are relevant to whether a payment is a security or damage deposit? Consider what terms you would include in a lease that you drafted for a landlord.





2. When must that consensual recognition of an obligation to repay exist? Does the following excerpt from Gilbert answer the question?


As we held in Buff v. Commissioner, 496 F.2d 847 (2d Cir. 1974), if he spends the loot instead of repaying, he cannot avoid tax on his embezzlement income simply by signing promissory notes later in the same year. See also id. at 849-50 (Oakes, J., concurring).


3. The withdrawals from the E.L. Bruce Company were “unauthorized.” Does that mean that there could not have been a “consensual recognition of an obligation to repay?”


4. If taxpayer has acquired funds without restriction as to their disposition, s/he has a power to spend them on consumption – one of the elements of the SHS definition of income. Did taxpayer Gilbert ever feel free to spend the money as he pleased?


5. It seems that taxpayer was willing to “bet the company” and had done so before. E.L. Bruce Company evidently willingly reaped the rewards of a good bet and only fired Gilbert when he made a bad one. Is that relevant to the income tax question that the facts of Gilbert raise?


6. Why are loan proceeds not included in taxpayer’s gross income? After all, taxpayer may act without restriction as to their disposition?


Wrap-up Questions for Chapter 2



1. What policies does a broad definition of “gross income” implement and how?


2. What is the tax treatment of a return of capital? How does this treatment implement the principle that we tax income once?


3. In determining whether a taxpayer should include certain forms of consumption in his/her gross income, why should it matter that taxpayer has no discretion in what it is he or she must consume (for example, a trip to Germany to view Volkswagon facilities)?


4. The use of appreciated property to pay for something implements the principal that we tax all income once. How?


5. What economic distortions result from the Code’s failure to tax imputed income?


Icon for the Creative Commons Attribution-ShareAlike 4.0 International License

Basic Income Tax by William P. Kratzke is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License, except where otherwise noted.


Leave a Reply

Your email address will not be published. Required fields are marked *