Amicus Curiae Brief — Commissioner of Internal Revenue v. Banks

Lo Co AUG I 6 Joo4

No. 03-892/03-907

IN THE

Supreme Court of the United States

COMMISSIONER OF INTERNAL REVENUE,

Petitioner,

Vv.

JOHN W. BANKS, II,

Respondent.

COMMISSIONER OF INTERNAL REVENUE,

Petitioner,

v.

SIGITAS J. BANAITIS,

Respondent.

On Writ of Certiorari

To the United States Courts of Appeals

For the Sixth and Ninth Circuits

BRIEF FOR AMICUS CURIAE

PROFESSOR CHARLES DAVENPORT

IN SUPPORT OF RESPONDENTS

Charles Davenport*

Rutgers Law School—Newark

423 Washington Street

Newark. New Jersey 07102

(973) 353-5384

(703) 893-8425

*Counsel of Record

Balmar Legal Publishing Services, Falls Church, VA (703) 289-9000

TABLE OF CONTENTS

Page

ee He actciitiionesentnctnasscisepinnunniotiiniiianatianiieel ii

INTEREST OF AMICUS CURIAE.........0c.eccsccsecsesvessseccecssevcessocsees l

SUMMARY OF ARGUMENT ...........cc.cccccccssssssosssrsssssesssessesenees l

fy ECT , _— inal

I. TAXPAYERS’ LEGAL FEES ARE TRAN-

SACTION COSTS, NOT DEDUCTIONS ................... 3

A. Taxpayers’ Tort Claims Are Property ............... 3

B. The Undisputed Treatment of Tran-

~- “ icttaiarcibiccinsinctapiittninbeninieriensisgptibie 5

C. The Legal Fees in These Cases are

eS GOOD cncesicstatiiatnitientnitinsinntiniienaniinl 8

D. The Disallowance of Deductions for

Transaction Cost Has Several Merits .............. 10

E. Simultaneity of Acquisition and

Disposition Does Not Change Rules for

FERRER COBGOD wrcncccsnsecensenencescocmecensstepunensie 12

Il. PETITIONER’S RELIANCE ON CASES OF

GRATUITOUS ASSIGNMENTS OF INCOME

IS IMPROPER. 13

A. The Assignments in These Cases Are

Not Gratuitous Assignmentts................sccssse0es 13

B. Petitioner’s Recent Rulings Contradict

PUSSIES © FOBT nccccescentcevsssesenintenpecsnseeecetiy 15

Ill. THE AMICI CURIAE BRIEF OF PROFESSORS

POLSKY AND HELLWIG 16

CONCLUSION....... 17

il

TABLE OF AUTHORITIES

CASES Page(s)

Alexander v. IRS, 72 F.3d 938 (1995) ......ccccccsssscessseeseeeeeeees 10

Baylin v. United States, 43 F.3d 1451

(Fred. Cir. 1995) q........--ossscososocssssoossessssosessessssssnsssssenssnee 8, 9, 10, 17

Blair v. Commissioner, 300 U.S. 5 (1937) .....ccccssccseeseeeeeeeee 15

Commissioner v. P.G. Lake, Inc., 356 U.S. 260,

(| aS ee 4, 14, 15

Commissioner v. Schleier, 513 U.S. 323, (1995) ..........cccceeeees 3

Dames & Moore v. Regan, 453 U.S. 654 (1981)........ccccceeeeee 4

Estate of Stranahan v. Commissioner, 472 F.2d 867

OF? Cle. 197 BP accrrcsstsentenvetiiiee vommntitiée 15

Helvering v. Horst, 311 U.S. 112 (1940) .....cccccesesesessseseeeeees 14

Helvering v. Union Pacific, 293 U.S. 282 (1934), reh.

Gan. ZB U.S. GEO (ISB) ncoccscccssescosssssssntnissintaiasinaaiaaatl 6, 7

Hort v. Commissioner, 313 U.S. 28 (1941)..............ccceeeeees 4,14

Inaja Land Co. v. Commisioner, 9 T.C. 727 (1947).........00000+ 8

INDOPCO, Inc. v. Commissioner, 503 U.S. 79

( BOE) .coccccoccccsecesssseessesnssisesineaiaeaaiuaaaaae 4, 6, 12, 13

Kirschenmann v. Commissioner, 488 F.2d 270 (1973).........+- 6

Lucas v. Bari, 281 U.S. 11 (SSBB ccccccccssssntsnsconensnnscnasiiiaiaians 13

New York Central Railroad Company v. White, 243 U.S.

OT) | NS eee 4

Ogilvie v. United States, 519 U.S. 579, (1996) .........ccccceeeseeee 3

Spreckels v. Commissioner, 315 U.S. 626 (1942) ...........00+ 6,7

True, Jr. v. United States, 894 F.2d 1197

i 2 | RE Meret 6,7

United States v. Burke, 504 U.S. 229 (1992),......-00+ Sibel 3

United States v. Midland-Ross, 381 U.S. 54, 57 (1965).......... 4

STATUTES

Internal Revenue Code of 1986 (26 U.S.C.):

i conigununeunin 11, 12

ES ELLA 7

SL SL SE EE 4,17

i cccumersnseneni 2,17

EEE a 3

OD enentisneninnccsesectessesescsnaseessonersensnsnnsszsee 1, 2, 11,12, 17

EE ES a 14

en Sh ee ella Neri 4

SR er 1, 2, 11, 12, 17

ESS EE TSE AD 5,17

EET TE OT 9

LE Senne 6

EES SE AE 14

ET eT 14

OS EES See ea 14

ESET ESE ES rc 14

Internal Revenue Code of 1939, § 23(a)(2) .....-.--sess-suessesneees 11

Revenue Act of 1913, 38 Stat. 114, § II(B), sixth ..............000. 6

Revenue Act of 1942, § 121(a)..........ssssssssssesessseseessneeeesnneeees 11

Tax Reform Act of 1986, P.L. 99-514, § 803............ccceseeseees 9

iv

REGULATIONS

26 C.F.R.

‘BRRRB, Tae, B BEG OGD ccsecssesnsesssssssssssssersssesnsestessmessnnenes 5

‘DUBE, Tham, B BEE IID cecccccseszscsssnssssensseseansnssnssnssmssensesnes 5

Treas. Reg. § 1.263(a)-4(e)( 1) ...........ccccccseesesescccesecseseeeesees 9,17

pT ee 9

pF | | 9

‘Bees. Fame, G BLD-GGRGE ccscansscnsssssensesssessscennssnssmsenesensesem 17

Teens. Reg. § 1Sa.4S3-1(O 2M V)...ccccccceccceccrcecssccvescosssscssscess 6

MISCELLANEOUS

Hellwig, Brant J., Tax Treatment of Legal Fees: The

Debate Continues, 97 Tax Notes 1235 (Dec. 2, 2002)........ 4

Hellwig, Brant J., Davenport's Capitalization Argument

Fails to Convince, 98 Tax Notes 433 (Jan. 20, 2003).......... 4

ee 6

og 6

aL 16

P.L.R. 200427009 (Mar. 19, 2004)..............ccccsccsescccesessesseees 16

Raby, Burgess J.W. and William L. Raby, Getting the

IRS to Pay the Costs of a Tax Controversy, 104 Tax

OU ee 3

Revenue Ruling 69-561, 1969-2 C.B.25 ........c.ccesseesseneseenseees 6

Revenue Ruling 68-528, 1968-2 C.B. 331 ...........ccesserserees a

INTEREST OF THE AMICUS CURIAE

This Amicus Curiae is a professor of law at Rutgers

University, Newark, New Jersey. Amicus offers a theory not

argued in the courts below. He has written a book on tax

accounting, a book on the determination of cost for

inventories, and, with another author, a second book on

inventory costs. His interest lies in the proper application of

tax doctrine. He has no other interest in the outcome of these

cases.’

SUMMARY OF THE ARGUMENT

The cases at bar may be resolved by application of

fundamental principles of federal income tax accounting not

urged below by any of the parties.

The legal fees in these cases were incurred to acquire and

dispose of Respondents’ tort claims against their employers.

Tort claims are intangible property. The costs of acquiring

and disposing of property are transaction costs, and

transaction costs are not deductible under either section 162

(dealing with business expenses) or 212 (dealing with

investment expenses) of the Internal Revenue Code.’ Rather,

transaction costs are offset directly against the proceeds

' Pursuant to this Court's Rule 37.3(a), letters from all parties

consenting to the filing of this brief have been filed with Clerk. Pursuant

to this Court’s Rule 37.6, Amicus states that this brief was not authored in

whole or in part by counsel for any party. Amicus received no monetary

contribution for the preparation or submission of this brief other than

reimbursement for the cost of printing this brief from Tax Analysts, a tax-

exempt, nonprofit educational organization that has no interest in these

cases but is interested, as a part of its exempt function, in sponsoring full

debate on important tax issues. The views presented in this brief are those

of the Amicus and should not be ascribed to either Tax Analysts or Rutgers

? 26 U.S.C. References to section numbers are to the Internal

Revenue Code of 1986 unless otherwise noted.

2

earned by the costs. Because the fees are not deductions, they

do not fall within the ambit of deductions disallowed in

computing the alternative minimum tax (AMT).

The tax rules just stated are well-recognized, familiar tax

doctrine routinely applied for many years. These rules

provide certainty, and we need not set out on an endless sea to

find another set of rules or perhaps to invent a new set of rules

for these cases. The rules for transaction costs properly match

costs against income. These rules are also administratively

convenient. Finally, neither Petitioner nor Amici Curiae

Professors Polsky and Hellwig give any good reason not to

apply the rules for transaction costs to the cases before the

Court. (Professors Polsky and Hellwig will be referred to as

Amici.)

Petitioner’s argument concerning assignments of income

is fundamentally flawed. It relies on doctrine announced in

cases of gratuitous assignment of income. Gratuitous

assignments arise in friendly transactions where the only

constraints on the form of the transaction are family wealth,

family control, and hoped-for tax results. These

and should not be applied to assignments for consideration.

Assignments for consideration are subject to well-developed

income tax doctrine easy of application in these cases. As

explained in the Argument below, Petitioner has issued recent

rulings that flatly contradict its position in these cases.

Amici argue that IRC section 83(h) allows a deduction

for the legal fees in these cases. It does not because the legal

fees at issue are nondeductible transaction costs. The

overriding principle that transaction costs may not be

deducted is as applicable to IRC section 83(h) as it is to IRC

sections 162 and 212. Amici’s reliance on section 83(h) is

misplaced.

i

i

under Petitioner’s and Amici’s arguments.

A. Taxpayers’ Tort Claims Are Property

These cases involve damage to a taxpayer’s person but

without physical injury and do not involve “personal injuries”

within the meaning of section 104(a).’ Even so, in tax

> United States v. Burke, 504 U.S. 229 (1992), 122 S.Ct. 186, 119

L.Ed. 34; Commissioner v. Schleier, 513 U.S. 323, 115 S.Ct. 2159, 132

L.Ed. 294 (1995); Ogilvie v. United States, 519 U.S. 579, 117 S.Ct. 45,

136 L.ED. 454 (1996); and section 104(a) as amended.

* Raby, Burgess J.W. and William L. Raby, “Getting the IRS to Pay

the Costs of a Tax Controversy,” Tax Notes, July 12, 2004, page 173.

* The term “quasi-tortious” conduct is used because many of the

taxpayers in cases presenting the issue before this Court founded their claims

on statutory provisions conferring rights that had not been recognized by the

common law. These cases are cited on page 3 of Brief for Amici.

* The argument in this brief is limited to cases of tort or quasi-tort

injuries to the person. Broader application, if appropriate, may await

another day. The cases in note 3 supra demonstrate the Court’s familiarity

with distinction between torts and contracts. Here the distinction is urged

not to afford exemption from tax, but to define a class of cases that is well

4

These injuries to the person produce tort claims, and tort

claims are property. In Dames & Moore v. Regan, 453 U.S.

654 (1981), this Court held that a cause of action could not be

taken without compensation. Similarly, this Court has held

that a tort claim may not be taken without due process. New

York Central Railroad Company v. White, 243 U.S. 188

~{1916). Even wispier intangibles are readily accepted as

property in the tax law. For example, a customer-based

intangible, a supplier-based intangible, know-how, a process,

a format, or other similar items are recognized as property.’ In

INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), a mere

future benefit (presumably from corporate synergies flowing

from a merger) was en igh to be treated as property.

Perhaps, Petitioner* will argue that injuries associated

with one’s person are not property because, if their disposition

produces income, the income is ordinary income.’ The

argument seems to be that property unable to be converted to

capital gain is somehow different, to the point of not being

property at all, from property that may produce capital gain.

Agreed. But only for the capital gain rules."* But the question

whether or not the taxpayers’ income is capital gain is not

understood both by the Court and lower courts.

” See section 197(d) codifying prior practice.

* Amici argue that section 83 applies to the causes of action in these

cases. Because section 83 applies only to property, an argument that the

causes of action in these cases are not property would seemingly be

difficult for Amici to sustain.

* Hellwig, Brant J.. “Tax Treatment of Legal Fees: The Debate

Continues,” Tax Notes, Dec. 2, 2002, page 1235 am Brant J. Hellwig,

“Davenport's Capitalization Argument Fails to Convince,” Tax Notes, Jan.

20, 2003, page 433.

" Hort v. Commissioner, 313 U.S 112,61 S.Ct 757, 85 L.Ed. 1168 (1941),

United States v. Midland-Ross, 381 U.S. 54, 85 S.Ct 1308, 14 L.Ed. 2d 214

(1965). Commissioner v. } 1s. Lake, Inc. 356 U.S. 260,78 S.Ct 1, 2 L.Ed.2d

743 (1958), reh. denied 356 U.S. 964, 78 S.Ct. 991, 2 L_Ed.2d 1071.

5

before the Court," and the distinction has nothing to do with

whether the taxpayers’ causes of action are property for other

purposes. Certainly, many items whose characterization as

property cannot be contested produce only ordinary income

when sold.

If the argument is as stated in the last paragraph, it brings

a very difficult capital gain issue into the very difficult AMT

arena, making the AMT arena even more difficult. Just why

capital gain lore, a thorny thicket, should be mixed with the

AMT is unclear. The only apparent reason for mixing capital

gain doctrine with the AMT is to prevent characterization of

the taxpayer’s causes of action as property and thus to refute

Amicus’s argument, below, that the rules on acquisition and

disposition of property apply to these causes of actions. If

those rules do not apply, so Petitioner may argue, the AMT

applies to taxpayers’ acquisition and disposition of their tort

claims. There is no other demonstrable benefit.

B. The Undisputed Treatment of Transaction Costs

Once the taxpayers’ tort claims are properly

characterized as property, a entire new vista for tax treatment

opens up." It is that the legal fees are transaction costs, and it

has been with us since the beginning of the income tax. What

is that vista? It is that the legal fees are transaction costs, and

transaction costs are not deductible. Section 263; Reg.

§ 1.263(a)-1(b) and Reg. § 1.263(a)-2(e). Instead, transaction

'! That question is not before the Court. ‘Time enough to deal with it if

it should arise. Amicus doubts that it will arise. The case cited by Amici

would then be relevant.

'2 Logically, there is little reason to limit the doctrine of capitalization

of transaction costs, to property. Rather, a properly defined transaction

would be the limitation, but Amicus does not in this brief argue for

application of the doctrine beyond an item properly characterized as

property.

') Reg. refers to regulations issued under the Internal Revenue Code of

1986 unless otherwise defined.

6

costs related to the acquisition and disposition of property are

offset against the recovery they produce. Only the remaining |

amount is included in income.

If the transaction is an acquisition, costs are added to the

basis of the acquired property. True, Jr. v. United States, 894

F.2d 1197 (10" Cir. 1990) and Revenue Rulings 69-551,

1969-2 C.B. 25 and 68-528, 1968-2 C.B. 331. If the

transaction costs are related to the disposition of property,

they are subtracted from the proceeds of the disposition with

only the remaining amount being realized as income."

Helvering v. Union Pacific, 293 U.S. 282 (1934, reh. denied

293 U.S. 630 (1934) and Spreckels v. Commissioner, 315 U.S.

626 (1942). This treatment of transaction costs has been

undisputed in the 91 years that the income tax has been with

us. Generally, this disallowance of deduction is, and will in

this brief sometimes be, called the capitalization doctrine.

The Court dealt with it extensively in INDOPCO, Inc. v.

Commissioner, supra.

This treatment is predicated on statutory language that,

in 1913, appeared and stiil today appears to deal only with the

acquisition costs. Section I1,(B), sixth, Act of 1913, 38 Stat.

114, disallowed deductions for “any anuount paid out for new

buildings, permanent improvements, or betterments, made to

increase the value of any property or estate.” Substantially,

the same language is found in section 263(a)(1) of the Internal

Revenue Code of 1986. Despite the apparent limitation to

'* The Internal Revenue Service has been a bit wobbly whether the

transaction costs offset the proceeds directly or are first added to basis and

then subtracted as basis from the proceeds to reach the amount of income

to be reported by the taxpayer. Compare, for example, IRS Publication

523, page 3 (offset to proceeds) to IRS Publication 544, page 4, and

Regulation § 15a.453-1(b\2)v) (included as an addition to basis). See

also Kirschenmann v. Commissioner, 488 F.2d 270 (1973), where the IRS

unsuccessfully contested the addition of selling expenses to basis but

argued that they should reduce the amount realized. rien

either technique is acceptable.

7

acquisitions, it is applied both to acquisition costs and

disposition costs. True, Jr. v. United States, supra, Helvering

v. Union Pacific, 293 U.S. 282 (1934), supra, and Spreckels v.

Commissioner, supra.

Application of this doctrine to the instant cases means

that the legal fees are not deductions. Rather, they are

transaction costs subtracted from the litigation or settlement

proceeds received by the taxpayers. Only the amount left

over is included in income. The alternative minimum tax is

not implicated because there are no deductions to be

disallowed by sections 56(b)(1 (A).

These rules for acquisition and sales of property may be

demonstrated by an example, here explained in terms of the

purchase and sale of real estate rather than tort claims because

Amicus believes that Petitioner will not dispute application of

these rules to real estate. The example will explain the

difference between treating transaction costs as subject to

capitalization (Amicus’s theory) and the deduction of

transaction costs (Petitioner’s position).

Suppose A buys a parcel of land for $900. A also pays a

and title insurance costs. Together the legal fees

payments are transaction costs, and assume that

$100. They are not deductible. Rather, A must capitalize

both the $900 purchase price and the $100 of transaction

costs A gets a basis of $1,000 for the total of the purchase

price and the transaction costs. Suppose that A sells the

parcel for $1,500. Assume'also that A hired a real estate

broker to make the sale and a lawyer to close the transaction.

Suppose that the broker was paid $90 and the lawyer $60.

These items total to $150, and they are transaction costs under

the law. When A calculates profit, A will reduce the $1,500

price received by the $1,000 cost plus the $150 of transaction

cost incurred on the sale. A will have gross income of only

$350 (whether characterized as capital gain or ordinary

income). This result accords with the economics of the

8

transaction. A is ahead by $350, and that is what A is taxed

on. These results are undisputable under present law, and the

result is not changed if A is subject to the AMT.

Amicus believes that Petitioner and Amici would agree

about the acquisition costs and that A would have a basis of

$1,000 for the parcel of land. Their theory, which Amicus

believes they would not apply to real estate but do apply to

taxpayers’ tort claims, would not allow the disposition costs

to offset the proceeds of sale. Rather, when the parcel is sold

for $1,500, the basis would be subtracted, and A would have

$500 of gross income. If the property produces capital gain,

A will have a capital gain cf $500. Under the regular tax, A

would be allowed to deduct the $150 of transaction costs

against any income that A had, but this deduction would not

be allowed for AMT purposes. Under the AMT, if Petitioner

and Amici are right, A would have $500 of income although A

is ahead economically by only $350.

The law indisputably requires capitalization of

transactions costs on voluntary sales of property and also on

involuntary sales. Baylin v. United States, 43 F.3d 1451 (Fed.

Cir. 1995). Also, on injuries to property. Inaja Land Co. v.

Commissioner, 9 T.C. 727 (1947). The question posed by the

cases at bar are whether these clear, uncontested rules for

transaction costs should be applied to Respondents’ causes of

action or whether the transaction costs are to be converted to

deductions. If that occurs, the deductions will be disallowed

under the AMT, and Respondents wil! be subject to tax on

much more than they gained economically from the lawsuits.

C. The Legal Fees in These Cases Are Transaction

Costs

The legal fees in the cases at bar are either acquisition

costs, disposition costs, or both. The taxpayers had a right,

created either by common law or by statute, violated by

tortious conduct. Legal fees were incurred to establish the

violation of a right, to show the extent of the damage, and

9

finally to settle on the amount due the taxpayers. These fees

were costs. They are directly traceable to a discrete,

recognizable transaction. The fees were necessary to the

acquisition of property, the causes of action, and the lawyers’

services disposed of this property by obtaining payment from

the defendants in the civil lawsuits.

The most recent definition of acquisition costs state

that an expenditure is a cost if it facilitates a transaction.

Reg. § 1.263(a)-4(e)(1)."° Certainly, the legal fees in

question here facilitated the acquisition and disposition of the

‘causes of action. Typically, an expenditure becomes an

expense rather than a transaction cost if it is an indirect cost

that cannot be traced to a specific transaction but rather might

have enabled a number of different transactions and produced

a number of different benefits."*

The legal fees in the present cases are very similar to

those incurred in Baylin v. United States, supra. In Baylin,

Mr. Baylin had property taken by the State of Maryland. He

was unable to contest the taking of the property, just as the

taxpayers in these cases were unable to contest the damage

left to post-injury damages. When the State did not offer

what Mr. Baylin thought was sufficient, he went to court and

contested the amount. He prevailed and recovered a much

'S These regulations do not deal with disposition costs and cannot be

expected to define a disposition cost. One supposes amounts paid to

facilitate a disposition would be treated as transaction costs because that

eS ee ee eee eee

regulations on acquisitions.

'* For example, the IRS has issued a number of regulations related to

indirect costs of inventories, and in 1986, the Congress required indirect

costs to be capitalized as a part of the costs of property in accordance with

section 263A. Section 803 of the Tax Reform Act of 1986, P.L. 99-514.

These prior regulations can be found at Reg. § 1.471-3, T.D. 6336, Nov.

25, 1958, a and T.D. 6500, Nov. 9, 1960, amended by the T.D. 7285, and

Reg. § 1.471-11, T.D. 7285, Sept. 14, 1973.

10

larger sum than the State had offered. His legal fees were

subtracted from the award from the State, and he was taxed

upon the proceeds reduced by the legal fees. So clear is the

result’’ in Baylin that the Petitioner’s and Amici’s citation’ of

it as supporting them is inexplicable.

In Alexander v. IRS, 72 F.3d 938 (1995), cited by both

Petitioner and Amici as supporting their positions, the Court

of Appeals for the First Circuit did not allow a taxpayer to

offset legal fees against a settlement. The court did not adopt

the analysis made here, but one circuit court opinion should

not be dispositive of one issue.

The similarity of these cases to the taking of property in

Baylin v. United States, supra, argues strongly for application

to the cases at bar of the well-developed rules applied in

Baylin v. United States, supra. There is no articulated reason

for not applying Baylin.

D. The Disallowance of Deductions for Transaction

Costs Has Several Merits

Transactions cost are properly disallowed as deductions.

Disallowance of deductions produces a matching of cost

against its associated income. Matching of income and cost is

an important doctrine of income taxation and a fundamental

principle of accounting. Matching prevents the separation of

costs and income for the benefit of either taxpayers or the

government. The capitalization doctrine also can prevent

transaction costs related to the earning of capital gain income

from being deducted against ordinary income.” By the

'7 The court in Baylin said: “The IRS classified all of the legal fees as

a capital expenditure and calculated a capital gain . . . by adding all of the

legal fees to the basis of the condemned property. . .” at page 1453.

* See Petitioner's brief at page 23 and Amici’s brief at page 3.

? See the example in text above.

11

capitalization doctrine, transaction costs are given the same

character as the income earned by them.

The administrative convenience is important if the

statute does not demand inconvenience, and as argued in the

pages below, it does not in these cases. Under the

capitalization doctrine both taxpayers and the government

have their burdens minimized. They do not have to determine

whether transaction costs are deductions falling into itemized

deductions and allowed only if they exceed the standard

deduction. Or whether they constitute business or

nonbusiness deductions. Or, for that matter, get into the

determinations made in these cases.

Neither Petitioner nor Amici have argued that they reach

a proper economic result. They must acknowledge that under

their theory, after application of the AMT, taxpayers will be

taxed on amounts far greater than their economic income -

sometimes, even to the point that the taxpayers’ costs and

taxes exceed the amount of the recovery. That their results are

harsh is not, of course, an argument against them if that is

what the statute requires. But Petitioner cannot point to any

language in the statute (either the AMT provisions or sections

162 and 212) that mandate Petitioner’s results. Nothing in the

literature (whether committee or conference report, academic _

or professional journals, or learned treatises) surrounding

either the passage of section 162 (business deductions,

enacted as a part of the first income statute in 1913), section

212 (investment deductions, first enacted as section 23(a)(2)

of the Internal Kevenue Code of 1939 by section 121(a) of the

Revenue Act of 1942) or sections 55-59 (the alternative

minimum tax) vaguely suggests that the results pressed by

Petitioner and Amici were perceived by a single member of

the Congresses that have passed and later amended these

provisions. Lack of support in the literature, of course, would

not be harmful to their theory if their theory were required by

the statutory language of any of the provisions just cited. But

it is not, and in the absence of statutory language specifying

12

the results urged by Petitioner and Amici, this paucity of

materials in the literature is telling in the face of what the

Congresses must have known: Transactions costs are not

deductions. There is no indication that any member of any of

these Congresses ever thought that enactment of section 162,

section 212, or the AMT changed the capitalization rule.

The language of the statute (sections 55-59, 162, and

212) does not demand the harsh result urged by Petitioner and

Amici. Rather, an appropriate result taxing the taxpayer only

on economic gain can be reached within the wording of the

statute, and that result is consisterit with tax doctrine that was

reached under the original income tax act and that has

prevailed since.

E. Simultaneity of Acquisition and Disposition Does

Not Change Rules for Transaction Costs

This Amicus also thinks that Petitioner may argue that

capitalization does not apply when disposition of property is

almost simultaneous with its acquisition. Petitioner may

argue that IVDOPCO does not apply to cases with benefits so

evanescent. While JNDOPCO speaks of disallowing

deductions for amounts paid for future benefits, the opinion is

grounded on the premise that purchases of property are not

deductible expenses. Analytically, the cases before the Court

involve an acquisition of property through showing of an

injury, a valuing of the property, and finally a disposition of

the property through judgment or settlement. Each of these

steps can be thought of as a separate transaction with each

step having its costs capitalized. But the steps in these cases

are compressed into a single moment. This compression

gives no good reason for changing the rules applicable to each

step. If this Court were to hold that this compression

somehow makes capitalization inapposite, taxpayers

sufficiently advised will effectively have an_ election.

Separate the steps and have capitalization apply; compress the

steps and have the yet-to-be-announced rule apply. The

simultaneity of the acquisition, valuing, and disposition

13

provides no justification for this election. The compressed

steps should remain subject to capitalization.

Under INDOPCO all expenditures are presumptively

capital in nature. The simultaneity of the acquisition of a valid

cause of action and its disposition should not change the

INDOPCO presumption and transform capital expenditures

imto deductions. The character of expenditures should not

turn on the order and timing of incurrence and disposition.

Amicus thinks that reply briefs may possibly question the

application of the capitalization doctrine by arguing that

drawing a line between transaction costs and deductions will

be difficult and that the Court should not introduce that kind

of uncertainty into the tax law. This difficulty is avoided, so

the argument may run, by treating all expenditures as

deductions. Amicus responds that doctrine should not be so

cavalierly overridden. There is no uncertainty in the instant

cases. This Court’s opinion upholding Amicus position would

mot introduce uncertainty. The Court would simply be hewing

to a line between transactions costs and deductions that

Il. Petitioner’s Reliance on Cases of Gratuitous

Assignments of Income Is Improper”

A. The Assignments in These Cases Are Not

Gratuitous Assignments

In its argument that taxpayers should include all of the

recoveries in income, Petitioner relies on venerable, reliable,

and still authoritative (sxcept to the extent changed by

subsequent statutes) opinions of the Court. The seminal case

was Lucas v. Earl, 281 U. S. 11 (1930). In 1901, well before

tthe enactment of the income tax in 1913, Mr. Earl assigned

* The Petitioner is correct that the tax treatment of legal fees is a

matter of federal law. It should not vary from state to state. Treating legal

the difficult analyses made by the courts below.

14

one-half of all of his subsequent earnings to his wife. After

enactment of the income tax, Mrs. Earl paid, and Mr. Earl did

not pay, tax on the earings she received under the

assignment. In a progressive income tax, the Earls’ splitting

of income reduced the overall tax. This treatment was

challenged by the government. It argued that Mr. Earl could

not avoid taxation on his earnings by giving them away to a

family member. The Court agreed. Swhsequently, in

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

applied to interest income on a corporate bond that Mr. Horst

gave to his son.

These holdings were necessary to prevent evisceration of

arbitrarily sought to shift income from family member to

family member in accordance with need or the tax brackets of

net wealth or income of the family as a whole.

The assignments of income in the cases before the Court

party bargained to obtain the best deal available. Self-interest

on each end of the bargain gives quite a different cast to the

rules that are applied.

Here is how these well-developed rules apply to

assignments for consideration. The assignor (taxpayers in

these cases) is taxed on the receipt of consideration. If the

consideration cannot be valued when the assignment is made,

taxation is deferred until it can be valued. Once the

consideration is valued and included in income, the assignor

receives a basis for the consideration. This basis is equal to

the value of the consideration received. The assignee is taxed

on the assigned income.” These rules are appropriate for the

** These rules have produced some difficulty when the assigned

interest is a carved-out interest. See for example, sections 167(e), 636,

1001(e), 1286, and 7872(b), and Hort v. Commissioner, supra note 10, or

Commissioner v. P.G. Lake, Inc., supra note 10. But these statutory

15

cases at bar. The negotiation between a client and a lawyer

do not produce gratuitous assignments. Rather, the client’s

assignment of a part of the prospective recovery is for value -

the lawyer’s promise to advocate the client’s case.

The inclusion in income of the value of the services

gives the client a basis for the legal services, and the services

and the basis given them have in turn been expended in

obtaining the balance of the settlement or judgment.” This is

unexceptional income tax doctrine. It should be applied to the

assignments in the cases at bar.”

might make an analogy to gratuitous assignments by saying that carved-

out assignments are the Earl, supra, and Horst, supra, cases while the

vertical slice is Blair v. Commissioner, 300 U.S. 5, 57 S.Ct. 330, 81 L.Ed.

» Cf. Brief of the Amici, pages 7-13.

16

contradict Petitioner’s position in this Court. In private letter

ruling 200344022 issued July 24, 2003, (and released to the

public on October 31, 2003), the IRS ruled that plaintiffs in a

class action lawsuit did not realize the amount of the legal

fees paid to counsel. The IRS reasoned that because the

plaintiffs had no contract with the lawyers, the fees were not

included in the plaintiffs’ income. If this Court upholds the

IRS in the cases at bar, the distinction arising from this private

letter ruling will encourage class action lawsuits. It would

also, apparently, distinguish between the plaintiff hiring the

lawyers in a class action suit (who have a contractual

relationship with the lawyers) and other plaintiffs, who also

benefit from the lawyer’s services. If this Court upholds the

IRS in the present cases, plaintiffs with the initiative to hire

lawyers will be subject to tax under the AMT, but the more

supine, less aggressive plaintiffs who lie back to benefit from

the class action will be exempted from the AMT.

In private letter ruling 200427009 (issued March 19,

2004, just a few days before certiorari was granted in these

cases and released to the public on July 2, 2004), the IRS

ambivalence about its position in this Court is even more

apparent. The taxpayer, in this ruling, a plaintiff in a lawsuit,

while recovery was still contingent on successful prosecution

of the action, assigned a portion of a recovery, if any, to a

second party in return for the second party’s foregoing claims

against the plaintiff. The IRS said that the portior of the

settlement paid the second party was not included in the

plaintiff's income as long as “recovery on such claim is

doubtful or contingent” at the time of the agreement with the

ruling with its argument in this Court.

Ill. The Amici Curiae Brief of Professors Polsky and

Hellwig

Most of the analysis in this brief does not differ from or

is not in conflict with that made by Amici. Divergence occurs

only on the question whether the amounts paid to taxpayers’

et on

17

lawyers were transaction costs or deductions. In support of

point out that section 83(h) allows a deduction under IRC

section 162 for amounts subject to section 83. They go on to

assert that the sharing of the proceeds of the litigation with the

lawyers is subject to section 83 and thus the language of

sections 83(h) makes the legal fees deductions. They do not

point out that the deduction allowed by section 83(h) is

subject to the capitalization doctrine jr'st as deductions under

sections 162 and 212 are.

This result is made explicit by Reg. § 1.83-6(a)(4) which

prohibits a deduction for a capital expenditure. This

prohibition is consistent with JVDOPCO, the overriding of

sections 162 and 212 by section 263, and the analysis in this

brief.

IV. Conclusion

The legal fees in these cases are transaction costs, not

expenses. The line between a tran:action cost and an expense

is not always easy to find, but in these cases it is bright.

Transaction costs are expenditures that facilitate the

transaction. Reg. § 1.263(a)-4(e)(1). The legal fees at issue

were incurred to value the rights taken from taxpayers and

then to dispose of the taxpayers’ causes of action arising from

tortious behavior. That is very similar to the taking and

valuing of the property in Baylin v. United States, supra. The

legal fees were not deductible in that case, and they are not in

these cases. They are transaction costs directly traceable to

proceeds, and they should be offset against the proceeds in

accordance with established income tax doctrine—as old as

the income tax itself.

Only expenses are subject to disallowance under the

AMT, and the legal fees subject of this proceeding are not

expenses.

18

The judgments of the Sixth and Ninth Circuits should be

remanded for proceedings consistent with the Court’s opinion

treating the legal fees as transaction costs, not as deductions.

August 2004

Respectfully Submitted,

Charles Davenport*

Rutgers University Law School-Newark

123 Washington Street

Newark, New Jersey 07102

(973) 353-5384

(703) 893-8425.

*Counsel of Record

Te

ee

So RS I

la

APPENDIX

IRC § 56(b) Adjustments applicable to individuals. —

Se eee

income of any taxpayer (other than a corporation), the

following treatment shall apply (in lieu of the treatment

applicable for purposes of computing the regular tax:

(1) Limitation on deductions

(A) In general

No deduction shall be allowed. —

(i) for any miscellaneous itemized deduction (as

defined in section 67(b)).... —

IRC § 67(b) Miscellaneous itemized deductions. —

For the purposes of this section, the term “miscellaneous

itemized deductions” means the itemized deductions other

than —

[There follows a list of exceptions not relevant to these

cases. |

IRC § 162(a) In general. — There shall be allowed as a

deduction all of the ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or

ses

L.R.C. § 197(d) — Section 197 intangible. —

For purposes of this section —

(1) In general

Except as otherwise provided in this section, the term

“section 197 intangible” means —

(A) goodwill,

(B) going concern value,

2a

(C) any of the following intangible items:

(i) work force in place including its composition

and terms and conditions (contractual or

otherwise) of its employment,

(ii) business books and records, operating systems,

or any other information base (including lists

or other information with respect to current or

prospective customers),

(iii) any patent, copyright, formula, process, design,

pattern, know-how, format, or other similar

item,

(iv) any customer-based intangible,

(v) any supplier-based intangible, and

(vi) any other similar item,

(D) any license, permit, or other right granted by a

governmental unit or an agency or instrumentality

thereof,

(E) any covenant not to compete (or other arrangement

to the extent such arrangement has substantially the

same effect as a covenant not to compete) entered

into in connection with an acquisition (directly or

indirectly) of an interest in a trade or business or

substantial portion thereof, and

(F) any franchise, trademark, or trade name.

(2) Customer-based intangible

(A) In general

The term “customer-based intangible” means —

(i) composition of market,

(ii) market share, and

SEPT ow

_ eee -

3a

(iii) any other value resulting from future provision

of goods or services pursuant to relationships

(contractual or otherwise) in the ordinary

course of business with customers.

(B) Special rule for financial institutions

In the case of a financial institution, the term “customer-

based intangible” includes deposit base and similar

items.

(3) Supplier-based intangible

The term “supplier-based intangible” means any value

resulting from future acquisitions of goods or services

pursuant to relationships (contractual or otherwise) in the

ordinary course of business with suppliers of goods or

services to be used or sold by the taxpayer.

***

IRC § 212 Expenses for the production of income. — In

the case of an individual, there shall be allowed as a deduction

all the ordinary and necessary expenses paid or incurred

during the taxable year —

(1) for the production or collection of income;

(2) for the management, conservation, or maintenance

of property held for the production of income; or. . .

L.R.C. § 263 — Capital expenditures

(a) General rule

No deduction shall be allowed for —

(1) Any amount paid out for new buildings or for

permanent improvements or betterments made to

increase the value of any property or estate.

Treas. Reg. § 1.263(a)-1(b) — In general, the amounts referred

to in paragraph (a) of this section include amounts paid or

4a

incurred (1) to add to the value, or substantially prolong the

useful life, of property owned by the taxpayer, such as plant

or equipment, or (2) to adapt property to a new or different

use. Amounts paid or incurred for incidental repairs and

maintenance of property are not capital expenditures within

the meaning of subparagraphs (1) and (2) of this

paragraph . . . . Capital expenditures are subsequently

recovered through depreciation, amortization, cost of goods

sold, as an adjustment to basis, or otherwise, at such time as

the property to which the amount relates is used, sold, or

otherwise disposed of by the taxpayer, in accordance with

applicable code sections and guidance published by the

secretary.

Treas. Reg. § 1.263(a)-2(e) — Commissions paid in purchasing

securities. Commissions paid in selling securities are an offset

against the selling price, except that in the case of dealers in

securities such commissions may be treated as an ordinary

and necessary business expense.

Treas. Reg. § 1.263(a)-4(e)(1) — Scope of facilitate —

(i) In general.

Except as otherwise provided in this section, an amount

is paid to facilitate the acquisition or creation of an

intangible (the transaction) if the amount is paid in the

process of investigating or otherwise pursuing the

transaction. Whether an amount is paid in the process of

investigating or otherwise pursuing the transaction is

determined based on all of the facts and circumstances.

In determining whether an amount is paid to facilitate a

transaction, the fact that the amount would (or would

not) have been paid but for the transaction is relevant,

but is not determinative. An amount paid to determine

the value or price of an intangible is an amount paid in

the process of investigating or otherwise pursuing the

transaction.

ee

Sa

Treas. Reg. § 15a.453-1(b)(2)(v) — Gross profit defined.

. . . For sales in taxable years ending after October 19, 1980,

in the case of sales of real property by a person other than a

dealer and casual sales of personal property, commissions and

other selling expenses shall be added to basis for purposes of

determining the proportion of payments which is gross profit

attributable to the disposition. . . .