The Tax Formula
MINUS § 62 deductions
EQUALS (adjusted gross income (AGI))
➔MINUS (standard deduction or
MINUS (personal exemptions)
EQUALS (taxable income)
Compute income tax liability from tables in § 1 (indexed for inflation)
MINUS (credits against tax)
After Glenshaw Glass (chapter 2, supra), we know that one element of “gross income” that taxpayer must recognize is that the taxpayer must have dominion and control of it. After Cottage Savings & Loan (chapter 2, supra), we are aware that a realization requirement applies to deductions as well as to income. It is not always obvious just exactly when taxpayer has dominion and control. Consider some possible problematic scenarios:
- Taxpayer has “dominion and control” over money that clearly would count as “gross income” but in a subsequent year learns that s/he must give the money back.
- Taxpayer has “dominion and control” over money but knows that s/he might have to return it if certain contingencies occur. For example, taxpayer has been paid money but the judgment on which his/her receipt of money was based has been appealed. Taxpayer might lose the appeal and have to return the money. In the meantime, taxpayer may spend the money anyway s/he chooses.
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.
- Taxpayer has entered into a contract that calls for various acts of performance to occur over more than one year, perhaps many years. The taxpayer pays expenses in some years and receives payments in some years. However, in any given year, there is no matching of expenditures and receipts by transaction. In some years, expenses are very high; in other years receipts are very high. When taxpayer does receive money, s/he may spend it any way s/he chooses.
The Internal Revenue Code requires taxpayers to compute their taxable income annually. See § 441. This can prove to be quite inconvenient for a taxpayer – and even a bit misleading if we apply this principle to the third scenario above, i.e., where taxpayer enters into a contract calling for performance over a long period of time. Should there be any principle by which we can mitigate the failure to match the expenses and income derived from a particular transaction?
Burnet v. Sanford & Brooks, 282 U.S. 359 (1931)
MR. JUSTICE STONE delivered the opinion of the Court.
In this case, certiorari was granted, 281 U.S. 707, to review a judgment of the court of appeals for the Fourth Circuit, reversing an order of the Board of Tax Appeals, which had sustained the action of the Commissioner of Internal Revenue in making a deficiency assessment against respondent for income and profits taxes for the year 1920.
From 1913 to 1915, inclusive, respondent, a Delaware corporation engaged in business for profit, was acting for the Atlantic Dredging Company in carrying out a contract for dredging the Delaware River, entered into by that company with the United States. In making its income tax returns for the years 1913 to 1916, respondent added to gross income for each year the payments made under the contract that year, and deducted its expenses paid that year in performing the contract. The total expenses exceeded the payments received by $176,271.88. The tax returns for 1913, 1915, and 1916 showed net losses. That for 1914 showed net income.
In 1915, work under the contract was abandoned, and in 1916 suit was brought in the Court of Claims to recover for a breach of warranty of the character of the material to be dredged. Judgment for the claimant was affirmed by this Court in 1920. United States v. Atlantic Dredging Co., 253 U.S. 1. It held that the recovery was upon the contract, and was “compensatory of the cost of the work, of which the government got the benefit.” From the total recovery, petitioner received in that year the sum of $192,577.59, which included the $176,271.88 by which its expenses under the contract had exceeded receipts from it, and accrued interest amounting to $16,305.71. Respondent having failed to include these amounts as gross income in its tax returns for 1920, the Commissioner made the deficiency assessment here involved, based on the addition of both items to gross income for that year.
The court of appeals ruled that only the item of interest was properly included, holding, erroneously, as the government contends, that the item of $176,271.88 was a return of losses suffered by respondent in earlier years, and hence was wrongly assessed as income. Notwithstanding this conclusion, its judgment of reversal and the consequent elimination of this item from gross income for 1920 were made contingent upon the filing by respondent of amended returns for the years 1913 to 1916, from which were to be omitted the deductions of the related items of expenses paid in those years. Respondent insists that, as the Sixteenth Amendment and the Revenue Act of 1918, which was in force in 1920, plainly contemplate a tax only on net income or profits, any application of the statute which operates to impose a tax with respect to the present transaction, from which respondent received no profit, cannot be upheld.
If respondent’s contention that only gain or profit may be taxed under the Sixteenth Amendment be accepted without qualification, seeEisner v. Macomber, 252 U.S. 189; Doyle v. Mitchell Brothers Co., 247 U.S. 179, the question remains whether the gain or profit which is the subject of the tax may be ascertained, as here, on the basis of fixed accounting periods, or whether, as is pressed upon us, it can only be net profit ascertained on the basis of particular transactions of the taxpayer when they are brought to a conclusion.
All the revenue acts which have been enacted since the adoption of the Sixteenth Amendment have uniformly assessed the tax on the basis of annual returns showing the net result of all the taxpayer’s transactions during a fixed accounting period, either the calendar year or, at the option of the taxpayer, the particular fiscal year which he may adopt. Under ... the Revenue Act of 1918, 40 Stat. 1057, respondent was subject to tax upon its annual net income, arrived at by deducting from gross income for each taxable year all the ordinary and necessary expenses paid during that year in carrying on any trade or business, interest and taxes paid, and losses sustained, during the year. ... [G]ross income “includes ... income derived from ... business ... or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatever.” The amount of all such items is required to be included in the gross income for the taxable year in which received by the taxpayer, unless they may be properly accounted for on the accrual basis under § 212(b). SeeUnited States v. Anderson, 269 U.S. 422; Aluminum Castings Co. v. Rotzahn, 282 U.S. 92.
That the recovery made by respondent in 1920 was gross income for that year within the meaning of these sections cannot, we think, be doubted. The money received was derived from a contract entered into in the course of respondent’s business operations for profit. While it equalled, and in a loose sense was a return of, expenditures made in performing the contract, still, as the Board of Tax Appeals found, the expenditures were made in defraying the expenses incurred in the prosecution of the work under the contract, for the purpose of earning profits. They were not capital investments, the cost of which, if converted, must first be restored from the proceeds before there is a capital gain taxable as income. SeeDoyle v. Mitchell Brothers Co., supra, 247 U.S. at 185.
That such receipts from the conduct of a business enterprise are to be included in the taxpayer’s return as a part of gross income, regardless of whether the particular transaction results in net profit, sufficiently appears from the quoted words of § 213(a) and from the character of the deductions allowed. Only by including these items of gross income in the 1920 return would it have been possible to ascertain respondent’s net income for the period covered by the return, which is what the statute taxes. The excess of gross income over deductions did not any the less constitute net income for the taxable period because respondent, in an earlier period, suffered net losses in the conduct of its business which were in some measure attributable to expenditures made to produce the net income of the later period.
But respondent insists that, if the sum which it recovered is the income defined by the statute, still it is not income, taxation of which without apportionment is permitted by the Sixteenth Amendment, since the particular transaction from which it was derived did not result in any net gain or profit. But we do not think the amendment is to be so narrowly construed. A taxpayer may be in receipt of net income in one year and not in another. The net result of the two years, if combined in a single taxable period, might still be a loss, but it has never been supposed that that fact would relieve him from a tax on the first, or that it affords any reason for postponing the assessment of the tax until the end of a lifetime, or for some other indefinite period, to ascertain more precisely whether the final outcome of the period, or of a given transaction, will be a gain or a loss.
The Sixteenth Amendment was adopted to enable the government to raise revenue by taxation. It is the essence of any system of taxation that it should produce revenue ascertainable, and payable to the government, at regular intervals. Only by such a system is it practicable to produce a regular flow of income and apply methods of accounting, assessment, and collection capable of practical operation. It is not suggested that there has ever been any general scheme for taxing income on any other basis. … While, conceivably, a different system might be devised by which the tax could be assessed, wholly or in part, on the basis of the finally ascertained results of particular transactions, Congress is not required by the amendment to adopt such a system in preference to the more familiar method, even if it were practicable. It would not necessarily obviate the kind of inequalities of which respondent complains. If losses from particular transactions were to be set off against gains in others, there would still be the practical necessity of computing the tax on the basis of annual or other fixed taxable periods, which might result in the taxpayer’s being required to pay a tax on income in one period exceeded by net losses in another.
Under the statutes and regulations in force in 1920, two methods were provided by which, to a limited extent, the expenses of a transaction incurred in one year might be offset by the amounts actually received from it in another. One was by returns on the accrual basis ..., which provides that a taxpayer keeping accounts upon any basis other than that of actual receipts and disbursements, unless such basis does not clearly reflect its income, may, subject to regulations of the Commissioner, make its return upon the basis upon which its books are kept. SeeUnited States v. Anderson, and Aluminum Castings Co. v. Routzahn, supra. The other was under Treasury Regulations (Article 121 of Reg. 33 of Jan. 2, 1918 ... providing that, in reporting the income derived from certain long-term contracts, the taxpayer might either report all of the receipts and all of the expenditures made on account of a particular contract in the year in which the work was completed or report in each year the percentage of the estimated profit corresponding to the percentage of the total estimated expenditures which was made in that year.
... Respondent [does not] assert, that it ever filed returns in compliance either with these regulations ... or otherwise attempted to avail itself of their provisions; nor, on this record, do any facts appear tending to support the burden, resting on the taxpayer, of establishing that the Commissioner erred in failing to apply them. SeeNiles Bement Pond Co. v. United States, 281 U.S. 357, 361.
The assessment was properly made under the statutes. Relief from their alleged burdensome operation, which may not be secured under these provisions, can be afforded only by legislation, not by the courts.
Notes and questions:
1. Taxpayer was a dredger. It was hired by the government to do some dredging of a channel in the Delaware River. The Government represented that its probes of the river bottom had shown that the material to be removed was mainly mud and fine sand, but it did not guarantee the accuracy of its findings and indicated that bidders should perform their own tests. In fact, the Government probes had also revealed the presence of “impenetrable” materials. This is what caused taxpayer to cease work on the contract and to sue in the Court of Claims.
- In the absence of tax rules, parties would presumably enter into the most efficient contract possible insofar as matters of payments and performance are concerned.
- Do you think that the holding in this case would affect the terms of future contracts that may require more than one year to perform?
- What exactly was taxpayer’s contention?
2. The Court held out the possibility that taxpayer might keep accounts on the accrual basis or on a percentage-of-completion basis in the case of long-term contracts. What do you think these methods are? Would one or the other of these methods have been better for taxpayer? Why?
3. The Code of course now has one more mechanism by which a transaction in one year may offset a transaction in another: the net operating loss (§ 172). Taxpayers may use losses up to two years back and twenty years forward to offset income. See chapter 6, supra.
4. Interesting questions involving the impact of annual accounting on particular taxpayers arise when tax rates change. Tax rates often change because of war – they increase because of the war and decrease after the war.
United States v. Lewis, 340 U.S. 590 (1951)
MR. JUSTICE BLACK delivered the opinion of the Court.
Respondent Lewis brought this action in the Court of Claims seeking a refund of an alleged overpayment of his 1944 income tax. The facts found by the Court of Claims are: in his 1944 income tax return, respondent reported about $22,000 which he had received that year as an employee’s bonus. As a result of subsequent litigation in a state court, however, it was decided that respondent’s bonus had been improperly computed; under compulsion of the state court’s judgment, he returned approximately $11,000 to his employer. Until payment of the judgment in 1946, respondent had at all times claimed and used the full $22,000 unconditionally as his own, in the good faith though “mistaken” belief that he was entitled to the whole bonus.
On the foregoing facts, the Government’s position is that respondent’s 1944 tax should not be recomputed, but that respondent should have deducted the $11,000 as a loss in his 1946 tax return. See G.C.M. 16730, XV-1 Cum. Bull. 179 (1936). The Court of Claims, however, relying on its own case, Greenwald v. United States, 57 F. Supp. 569, held that the excess bonus received “under a mistake of fact” was not income in 1944, and ordered a refund based on a recalculation of that year’s tax. We granted certiorari because this holding conflicted with many decisions of the courts of appeals, see, e.g., Haberkorn v. United States, 173 F.2d 587, and with principles announced in North American Oil Consolidated v. Burnet, 286 U.S. 417.
In the North American Oil case, we said: “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.” 286 U.S. at 424. Nothing in this language permits an exception merely because a taxpayer is “mistaken” as to the validity of his claim. ...
Income taxes must be paid on income received (or accrued) during an annual accounting period. Cf. I.R.C. §§ 41, 42, and seeBurnet v. Sanford & Brooks Co., 282 U.S. 359, 363. The “claim of right” interpretation of the tax laws has long been used to give finality to that period, and is now deeply rooted in the federal tax system. See cases collected in 2 Mertens, Law of Federal Income Taxation, § 12.103. We see no reason why the Court should depart from this well settled interpretation merely because it results in an advantage or disadvantage to a taxpayer. [footnote omitted]
MR. JUSTICE DOUGLAS, dissenting.
The question in this case is not whether the bonus had to be included in 1944 income for purposes of the tax. Plainly it should have been, because the taxpayer claimed it as of right. Some years later, however, it was judicially determined that he had no claim to the bonus. The question is whether he may then get back the tax which he paid on the money.
Many inequities are inherent in the income tax. We multiply them needlessly by nice distinctions which have no place in the practical administration of the law. If the refund were allowed, the integrity of the taxable year would not be violated. The tax would be paid when due, but the government would not be permitted to maintain the unconscionable position that it can keep the tax after it is shown that payment was made on money which was not income to the taxpayer.
Notes and questions:
1. Marginal tax brackets decreased after the end of WWII. Hence, taxpayer’s deduction in 1946 did not save as much in income tax as the same amount of income in 1944 cost him.
2. Congress has enacted § 1341 to mitigate the effect of the Lewis rule. When § 1341 applies, taxpayer is required to pay a tax in the year of repayment that is the lesser of
- tax liability computed in that year with the repayment treated as a deduction, or
- tax liability computed by applying a credit equal in amount to the increase in tax liability caused by payment of income tax in the year of inclusion in gross income.
Notice that § 1341 does not reopen taxpayer’s tax return from the earlier tax year, thereby maintaining the integrity of the principle of annual accounting.
4. Read § 1341. Note carefully the conditions of its applicability, or the following two CALI lessons will be more difficult than they need to be.
5. Do the CALI Lesson, Basic Federal Income Taxation: Gross Income: Claim of Right Doctrine.
6. Do the CALI Lesson, Basic Federal Income Taxation: Taxable Income and Tax Computation: Claim of Right Mitigation Doctrine.
7. We might consider Lewis to be a case of “income first/deduction later.” What if we reverse that: “deduction first/income later?”
Alice Phelan Sullivan Corp. v. United States, 381 F.2d 399 (Ct. Cl. 1967)
Plaintiff ... brings this action to recover an alleged overpayment in its 1957 income tax. During that year, there was returned to taxpayer two parcels of realty, each of which it had previously donated and claimed as a charitable contribution deduction. The first donation had been made in 1939; the second, in 1940. Under the then applicable corporate tax rates, the deductions claimed ($4,243.49 for 1939 and $4,463.44 for 1940) yielded plaintiff an aggregate tax benefit of $1,877.49. 1
Each conveyance had been made subject to the condition that the property be used either for a religious or for an educational purpose. In 1957, the donee decided not to use the gifts; they were therefore reconveyed to plaintiff. Upon audit of taxpayer’s income tax return, it was found that the recovered property was not reflected in its 1957 gross income. The Commissioner of Internal Revenue disagreed with plaintiff’s characterization of the recovery as a nontaxable return of capital. He viewed the transaction as giving rise to taxable income and therefore adjusted plaintiff’s income by adding to it $8,706.93 – the total of the charitable contribution deductions previously claimed and allowed. This addition to income, taxed at the 1957 corporate tax rate of 52%, resulted in a deficiency assessment of $4,527.60. After payment of the deficiency, plaintiff filed a claim for the refund of $2,650.11, asserting this amount as overpayment on the theory that a correct assessment could demand no more than the return of the tax benefit originally enjoyed, i.e., $1,877.49. The claim was disallowed.
This court has had prior occasion to consider the question which the present suit presents. In Perry v. United States, 160 F. Supp. 270 (1958) (Judges Madden and Laramore dissenting), it was recognized that a return to the donor of a prior charitable contribution gave rise to income to the extent of the deduction previously allowed. 2 The court’s point of division – which is likewise the division between the instant parties – was whether the “gain” attributable to the recovery was to be taxed at the rate applicable at the time the deduction was first claimed or whether the proper rate was that in effect at the time of recovery. The majority, concluding that the Government should be entitled to recoup no more than that which it lost, held that the tax liability arising upon the return of a charitable gift should equal the tax benefit experienced at time of donation. Taxpayer urges that the Perry rationale dictates that a like result be reached in this case.
The Government, of course, assumes the opposite stance. Mindful of the homage due the principle of stare decisis, it bids us first to consider the criteria under which judicial reexamination of an earlier decision is justifiable. [The court considered standards upon which it was appropriate to reexamine a rule announced in an earlier decision ... and decided not to defer to its holding in Perry.] ...
A transaction which returns to a taxpayer his own property cannot be considered as giving rise to “income” – at least where that term is confined to its traditional sense of “gain derived from capital, from labor, or from both combined.” Eisner v. Macomber, 252 U.S. 189, 207 (1920). Yet the 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. Rothensies v. Electric Storage Battery Co., 329 U.S. 296 (1946); Estate of Block v. Commissioner, 39 B.T.A. 338 (1939), aff’d sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.), cert. denied, 311 U.S. 658 (1940). The only limitation upon that principle is the so-called “tax-benefit rule.” This rule permits exclusion of the recovered item from income so long as its initial use as a deduction did not provide a tax saving. California & Hawaiian Sugar Ref. Corp. v. United States, supra; Central Loan & Inv. Co. v. Commissioner, 39 B.T.A. 981 (1939). But where full tax use of a deduction was made and a tax saving thereby obtained, then the extent of saving is considered immaterial. The recovery is viewed as income to the full extent of the deduction previously allowed.
Formerly the exclusive province of judge-made law, the tax-benefit concept now finds expression both in statute and administrative regulations. Section 111 of the Internal Revenue Code of 1954 [prior to later amendment] accords tax-benefit treatment [only] to the recovery of bad debts, prior taxes, and delinquency amounts. [footnote omitted] Treasury regulations have “broadened” the rule of exclusion by extending similar treatment to “all other losses, expenditures, and accruals made the basis of deductions from gross income for prior taxable years ***” [footnote omitted] [except for depreciation recapture.]
Drawing our attention to the broad language of this regulation, the Government insists that the present recovery ... should be taxed in a manner consistent with the treatment provided for like items of recovery, i.e., that it be taxed at the rate prevailing in the year of recovery. We are compelled to agree.
... [The tax-benefit rule] is clearly adequate to embrace a recovered charitable contribution. SeeCalifornia & Hawaiian Sugar Ref. Corp., supra, 311 F.2d at 239. But the regulation does not specify which tax rate is to be applied to the recouped deduction, and this consideration brings us to the matter here in issue.
Ever since Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931), the concept of accounting for items of income and expense on an annual basis has been accepted as the basic principle upon which our tax laws are structured. “It is the essence of any system of taxation that it should produce revenue ascertainable, and payable to the government, at regular intervals. Only by such a system is it practicable to produce a regular flow of income and apply methods of accounting, assessment, and collection capable of practical operation.” 282 U.S. at 365. To insure the vitality of the single-year concept, it is essential not only that annual income be ascertained without reference to losses experienced in an earlier accounting period, but also that income be taxed without reference to earlier tax rates. And absent specific statutory authority sanctioning a departure from this principle, it may only be said of Perry that it achieved a result which was more equitably just than legally correct. 3
Since taxpayer in this case did obtain full tax benefit from its earlier deductions, those deductions were properly classified as income upon recoupment and must be taxed as such. This can mean nothing less than the application of that tax rate which is in effect during the year in which the recovered item is recognized as a factor of income. We therefore sustain the Government’s position and grant its motion for summary judgment. Perry v. United States, supra, is hereby overruled, and plaintiff’s petition is dismissed.
Notes and questions:
1. Congress has not taken up Judge Collins’s invitation, stated in the last footnote of the case, to enact the principle of Perry – as it did in the reverse situation through § 1341.
2. Read § 111.
3. Consider: In year 1, taxpayer’s total itemized deductions were $12,000. A portion of the itemized deductions was for his contribution of a parcel of land to his church, fmv = $7000, “so long as used for church purposes.” Taxpayer filed single. The standard deduction in year 1 for single persons was $6000. In year 4, the church decided not to use the land for church purposes and returned it to taxpayer.
- How much income must taxpayer include in his 2013 tax return?
3a. Same as #3, but the fmv of the land in year 1 was only $4000? Her total itemized deductions were $12,000.
- How much income must taxpayer include in his year 4 tax return?
3b. Same as #3, but the fmv of the land was $3000 and taxpayer’s total itemized deductions, including his charitable contribution, were $5000.
- How much income must taxpayer include in his year 4 tax return?