Opposition — Tennessee-Carolina Transportation, Inc. v. Commissioner

No. 78-818

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In the Supreme Court of the United States

OCTOBER TERM, 1978

TENNESSEE-CAROLINA TRANSPORTATION, INC.,

PETITIONER

Vv.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE SIXTH CIRCUIT

MEMORANDUM FOR THE RESPONDENT

IN OPPOSITION

WADE H. McCnreE, JR.

Solicitor General

Department of Justice

Washington, D.C. 20530

In the Supreme Court of the United States

OCTOBER TERM, 1978

No. 78-818

TENNESSEE-CAROLINA TRANSPORTATION, INC.,

PETITIONER

V.

COMMISSIONER OF INTERNAL REVENUE

ON PETITION FOR A WRIT OF CERTIORARI TO

THE UNITED STATES COURT OF APPEALS FOR

THE SIXTH CIRCUIT

MEMORANDUM FOR THE RESPONDENT

IN OPPOSITION

The question presented in this federal income tax case

is whether the courts below correctly held that the tax

benefit rule requires a corporation to include in its income

at the time of liquidation the fair market value of assets it

distributes to its parent corporation when it had

previously claimed a business expense deduction for the

cost of those assets.

The facts are undisputed and may be summarized as

follows: During 1966, Service Lines, Inc., a corporation

then engaged in the motor freight transportation business,

purchased truck tires and tubes, at a cost of $53,000.

Because the tires and tubes had a useful life of no more

than one year, Service deducted the $53,000 purchase

price as a business expense on its 1966 tax return. In 1967,

petitioner purchased 100% of Service’s stock and

thereafter liquidated Service aiid took direct possession of

(1)

Service’s assets. Pursuant to Section 334(b)(2) of the

Internal Revenue Code of 1954, petitioner claimed a

stepped-up basis in the previously-expensed tires and

tubes to reflect their value ($36,000) as of the date of

liquidation. Petitioner thereafter claimed a $36,000

deduction with respect to those tires and tubes (Pet. App.

A-2 to A-5; Pet. App. B-2).

On audit, the Commissioner of Internal Revenue

determined that Service was required to include in its

income at the time of the liquidation the fair market value

of the tires and tubes it distributed to petitioner. In a re-

viewed opinion with seven judges dissenting, the Tax

Court upheld the Commissioner’s determination (Pet.

App. A-1 to A-13).

The court of appeals affirmed (Pet. App. B-1 to B-9),

with one judge dissenting (Pet. App. B-10 to B-20). It held

that the tax benefit rule required Service to include the

previously-expensed tires and tubes in income because

there was an inconsistency between Service's expense

deductions and petitioner's (Service’s successor) claim to a

tax basis in that same property. In so ruling, the court

cited petitioner's concession that if Service had liquidated

under Section 337, the tax benefit rule would have

required that Service report as ordinary income the fair

market value of the tires and tubes that it previously

claimed as a_ business expense. In the court’s view,

“(there is no reason in either the statute or tax policy

for reaching a different result in this case merely because

Service and [petitioner] chose a §336 liquidation” (Pet.

App. B-S).

I. One of the fundamental principles upon wnich the

federal income tax is based is that income and expenses

are computed in accordance with a system of annual

accounting. Burnet v. Sanford & Brooks Co., 282 U.S. 359

(1931). Under this system, items of income and expenses

properly accruable and attributable to a particular taxable

year must be reported on the return for the year even

though circumstances may subsequently prevent the re-

ceipt of such income or the payment of such expenses.

For those events, the annual accounting system requires

that any adjustments made as a result of changed cir-

cumstances occurring in a subsequent year must be re-

ported on the return for the subsequent year and not for

the year in which the items were originally reported. See

Healy v. Commissioner, 345 U.S. 278 (1953).

The “tax benefit” rule is a judicial doctrine that is a

corollary of the annual accounting system. Under this

rule, amounts deducted from gross income in one taxable

year but “recovered” in a subsequent year must be

included in income in the year of recovery. Thus, for

example, if a taxpayer deducts state income taxes under

Section 164 of the Code and those taxes are refunded to

him in a subsequent year, he must include the tax refund

in his federal taxable income. As the Court of Claims

observed in Alice Phelan Sullivan Corp. v. United States,

381 F. 2d 399, 401 (1967): “{TJhe principle is well

engrained in our tax law that the return or recovery of

property that was once the subject of an income tax

deduction must be treated as income in the year of its

recovery.” See, e.g., Dobson v. Commissioner, 321 U.S.

231 (1944); Burnet v. Sanford & Brooks Co., supra; Home

Savings and Loan Ass’n v. United States, 514 F. 2d 1199

(9th Cir.), cert. denied, 423 U.S. 1015 (1975). Cf. Internal

Revenue Code of 1954, Section 111; United States v.

Skelly Oil Co., 394 U.S. 678 (1969).

The decision below correctly held that the tax benefit

rule required Service to include the liquidation value of

the tires and tubes in its income. Here, Service purchased

$53,000 worth of tires and tubes during 1966 and claimed

a business expense deduction for that year equal to their

full cost on the assumption that they would be consumed

in one taxable year. Rev. Rul. 59-249, 1959-2 Cum. Bull.

55. But subsequent events undermined the basis for that

assumption. As of its liquidation into petitioner, Service

had not completely consumed the tires and tubes in its

business. To the contrary, those items were still worth

$36,000 when Service distributed them in 1966 to peti-

tioner as a liquidating distribution. The fact that peti-

tioner claimed a tax basis in the equipment equal to its

fair market value as of Service’s liquidation shows that

they had value in that amount so as to cast doubt upon

Service’s previously claimed deduction. Under these

circumstances, the tax benefit rule requires the inclusion

in Service’s income of the value of the tires and tubes. As

the court of appeals observed (Pet. App. B-7), “{tJhis

transfer belied the assumption that they would be wholly

consumed by Service. Thus, in order for Service to be

able to transfer them to taxpayer they must be deemed

to have been recovered by Service at that time.”

2. Contrary to petitioner's contention (Pet. 8), the

decision below does not conflict with Section 336 of the

Code. That provision states that “no gain or loss shall be

recognized to a corporation on the distribution of

property in partial or complete liquidation.” But as the

court of appeals correctly pointed out (Pet. App. B-4 to

B-5), it is well settled that the similar nonrecognition rule

of Section 337 applicable to liquidating corporations does

not bar the application of judicial doctrines such as

assignment of income or the tax benefit rule. Thus, for

example, if Service had liquidated under Section 337 and

sold its tires and tubes for $36,000, the tax benefit rule

would have required it to include that $36,000 in income

notwithstanding the terms of Section 337, which permit

the nonrecognition of gain from the sale of property by a

liquidating corporation. See, e.g., Commissioner v.

Anders, 414 F. 2d 1283 (10th Cir.), cert. denied, 396 U.S.

958 (1969); Spitalny v. United States, 430 F. 2d 195 (9th

Cir. 1970). Similarly, the assignment of income doctrine

has been held to require a corporation to recognize

income with respect to a liquidating distribution of work

in process despite the nonrecognition rule of Section 337.

Storz v. Commissioner, 583 F. 2d 972 (8th Cir. 1978);

Midland-Ross Corp. v. United States, 485 F. 2d 110 (6th

Cir. 1973). As the court of appeals correctly concluded,

“(t]here is no reason in either the statute or tax policy for

reaching a different result in this case merely because

Service and [petitioner] chose a §336 liquidation” (Pet.

App. B-5).

Nash v. United States, 398 U.S. 1 (1970), upon which

petitioner relies (Pet. 5-6), is distinguishable. There, this

Court held that the tax benefit rule did not require the

members of a partnership to include in income the

amount of bad debt reserves attributable to the part-

nership’s accounts receivable upon the partnership’s

Section 351 transfer of its assets to a corporation in

exchange for stock. In so holding, the Court rejected the

Commissioner’s argument that the winding up of the

partnership's business terminated its need for the bad debt

reserve and that termination was a recovery of an item

that produced an income tax benefit within the ambit of

the tax benefit rule. As the Court viewed the matter, since

the value of the stock was equal to the net value of the

receivables (face amount less the reserve), there was no

recovery of any item.

Here, however, Service transferred equipment to

petitioner that Service had entirely written off but:which

had an undisputed value of $36,000, as demonstrated by

petitioner’s claim of basis in that amount. As the court of

appeals correctly observed (Pet. App. B-8), “Thus, unlike

the instant case, in Nash the taxpayers did not transfer an

item (or any portion thereof) which had been the subject

of a prior deduction, but rather transferred only what was

left after the deduction. Here, Service clearly transferred

items which had been the subject of prior deductions”

(emphasis in original). See Rev. Ruls. 78-278, 78-279,

1978-30 Int. Rev. Bull. 5, 6 (July 24, 1978).

6

3. Finally, petitioner argues (Pet. 4-5, 7) that the

decision below conflicts with Commissioner v. South

Lake Farms, Inc., 324 F. 2d 837 (9th Cir. 1963). There, a

corporation liquidated and transferred its assets (un-

harvested crops with respect to which it had claimed

growing expenses) to a second corporation which owned

all of its stock. The Commissioner sought to include in

the income of the liquidating corporation the liquidation

date value of its unharvested crops under Section 446(b)

or alternatively deny it a deduction for the crop growing

expenses under Section 482. The Tax Court rejected both

contentions (36 T.C. 1027 (1961)). In the court of appeals,

the Commissioner abandoned his Section 482 argument

and relied solely upon Section 446(b), which provides that

“if the method [of accounting] used [by a taxpayer] does

not clearly reflect income, the computation of taxable

income ll be made under such method as, in the

opinion of the [Commissioner], does clearly reflect

income.”

A divided court of appeals affirmed. It ruled that no

method of accounting would have required the liquidating

corporation to include the value of its unharvested crops

in income. It further held that Section 446(b) could not be

used to disallow the crop growing expenses to the

liquidating corporation. As the court stated, “(t]o use

section 446(b) in this case as proposed would, we think,

circumvent the provisions and purposes of sections 334

and 336 of the Code” (324 F. 2d at 839). In so holding,

the court rejected the Commissioner’s argument that the

liquidating corporation received a tax benefit from the

crop growing expenses and recovered that item through

an enhanced price upon the sale of its stock.

To be sure, the Ninth Circuit’s observations in South

Lake Farms with respect to Section 336 are not entirely

consistent with the analysis of the court below. Thus, the

court of appeals in this case rejected the authority in

South Lake Farms (Pet. App. B-6 n.13) and the

dissenting judge heavily relied upon it (Pet. App. B-15 to

B-17). But the decision in South Lake Farms can be read

as principally turning upon the Ninth Circuit’s view that

the Commissioner’s authority under Section 446(b) to

prescribe methods of accounting did not extend to the

disallowance of the liquidating corporation’s crop

growing expenses. In this sense, the court’s statements

with respect to Section 336 and the tax benefit rules were

dicta that were not essential to its holding with respect to

Section 446(b). Indeed, since its decision in that case, the

Ninth Circuit has cast doubt upon its dicta in South Lake

Farms by holding in two cases that neither Section 336

nor 337 bar application of the tax benefit rule to

liquidating corporations. Spitalny y. United States, 430

F. 2d 195 (9th Cir. 1970) (tax benefit rule requires inclu-

sion in income of previously-expensed cattle feed by cor-

poration liquidating under Section 337); Home Savings

and Loan Ass'n v. United States, 514 F. 2d 1199 (9th

Cir.), cert. denied, 423 U.S. 1015 (1975) (tax benefit rule

requires inclusion in income of bad debt reserve by sav-

ings and loan association liquidating under Section 336).

These subsequent decisions, which are in accord with the

rationale of the court below, suggest that the dicta in

South Lake Farms may no longer represent the

authoritative view of the Ninth Circuit with respect to the

question presented in this case.!

'In Home Savings and Loan, the court stated that it did not intend

to impair the authority of South Lake Farms (514 F. 2d at 1201 n.1).

But the court made that statement in the course of observing that the

taxpayer in that case was not asserting that South Lake Farms stood

for the proposition that the accrual of earned but not reserved income

was improper. Thus, to the eatent that the court intended to

preserve the authority of South Lav:e Farms, it was with respect to its

holding dealing with Section 444b) and not the dicta addressing

Section 336 and the tax benefit rule.

It is therefore respectfully submitted that the petition

for a writ of certiorari should be denied.

WaDE H. McCreg, Jr.

Solicitor General

JANUARY 1979

DOJ-1979-01