The following materials should make the point that matching income and expenses with respect to character is more than simply the rule of some Code sections: it is a principle that pervades construction of the Code.
Arrowsmith v. Commissioner, 344 U.S. 6 (1952)
MR. JUSTICE BLACK delivered the opinion of the Court.
This is an income tax controversy growing out of the following facts ... In 1937, two taxpayers, petitioners here, decided to liquidate and divide the proceeds of a corporation in which they had equal stock ownership. Partial distributions made in 1937, 1938, and 1939 were followed by a final one in 1940. Petitioners reported the profits obtained from this transaction, classifying them as capital gains. They thereby paid less income tax than would have been required had the income been attributed to ordinary business transactions for profit. About the propriety of these 1937-1940 returns there is no dispute. But, in 1944, a judgment was rendered against the old corporation and against Frederick R. Bauer, individually. The two taxpayers were required to and did pay the judgment for the corporation, of whose assets they were transferees. [citations omitted]. Classifying the loss as an ordinary business one, each took a tax deduction for 100% of the amount paid. ... The Commissioner viewed the 1944 payment as part of the original liquidation transaction requiring classification as a capital loss, just as the taxpayers had treated the original dividends as capital gains. Disagreeing with the Commissioner, the Tax Court classified the 1944 payment as an ordinary business loss. Disagreeing with the Tax Court, the Court of Appeals reversed, treating the loss as “capital.” This latter holding conflicts with the Third Circuit’s holding in Commissioner v. Switlik, 184 F.2d 299. Because of this conflict, we granted certiorari.
I.R.C. § 23(g) [(1222)] treats losses from sales or exchanges of capital assets as “capital losses,” and I.R.C. § 115(c) [(331)] requires that liquidation distributions be treated as exchanges. The losses here fall squarely within the definition of “capital losses” contained in these sections. Taxpayers were required to pay the judgment because of liability imposed on them as transferees of liquidation distribution assets. And it is plain that their liability as transferees was not based on any ordinary business transaction of theirs apart from the liquidation proceedings. It is not even denied that, had this judgment been paid after liquidation, but during the year 1940, the losses would have been properly treated as capital ones. For payment during 1940 would simply have reduced the amount of capital gains taxpayers received during that year.
It is contended, however, that this payment, which would have been a capital transaction in 1940, was transformed into an ordinary business transaction in 1944 because of the well established principle that each taxable year is a separate unit for tax accounting purposes. United States v. Lewis, 340 U.S. 590; North American Oil Consolidated v. Burnet, 286 U.S. 417. But this principle is not breached by considering all the 1937-1944 liquidation transaction events in order properly to classify the nature of the 1944 loss for tax purposes. Such an examination is not an attempt to reopen and readjust the 1937 to 1940 tax returns, an action that would be inconsistent with the annual tax accounting principle.
MR. JUSTICE DOUGLAS, dissenting. [omitted]
MR. JUSTICE JACKSON, whom MR. JUSTICE FRANKFURTER joins, dissenting.
This problem arises only because the judgment was rendered in a taxable year subsequent to the liquidation.
Had the liability of the transferor-corporation been reduced to judgment during the taxable year in which liquidation occurred, or prior thereto this problem under the tax laws, would not arise. The amount of the judgment rendered against the corporation would have decreased the amount it had available for distribution, which would have reduced the liquidating dividends proportionately and diminished the capital gains taxes assessed against the stockholders. Probably it would also have decreased the corporation’s own taxable income.
Congress might have allowed, under such circumstances, tax returns of the prior year to be reopened or readjusted so as to give the same tax results as would have obtained had the liability become known prior to liquidation. Such a solution is foreclosed to us, and the alternatives left are to regard the judgment liability fastened by operation of law on the transferee as an ordinary loss for the year of adjudication or to regard it as a capital loss for such year.
I find little aid in the choice of alternatives from arguments based on equities. One enables the taxpayer to deduct the amount of the judgment against his ordinary income which might be taxed as high as 87%, while, if the liability had been assessed against the corporation prior to liquidation, it would have reduced his capital gain which was taxable at only 25% (now 26%). The consequence may readily be characterized as a windfall (regarding a windfall as anything that is left to a taxpayer after the collector has finished with him).
On the other hand, adoption of the contrary alternative may penalize the taxpayer because of two factors: (1) since capital losses are deductible only against capital gains plus $1,000, a taxpayer having no net capital gains in the ensuing five years would have no opportunity to deduct anything beyond $5,000, and, (2) had the liability been discharged by the corporation, a portion of it would probably, in effect, have been paid by the Government, since the corporation could have taken it as a deduction, while here, the total liability comes out of the pockets of the stockholders.
Notes and Questions:
1. Upon liquidation of a corporation, the corporation distributes its assets to its shareholders in exchange for their stock. Shareholders treat this as a sale or exchange of a capital asset. § 331(a). Recall from our discussion of Gilliam that payment of a tort judgment would have been an ordinary and necessary business expense, deductible under § 162(a).
2. The opinion of Justice Jackson spells out just what is at stake. First, recognition of capital losses would save taxpayers less than recognition of the same losses as ordinary. Second, long term capital losses are – except to the narrow extent permitted by § 1211 – only offset by long-term capital gains. If a taxpayer does not or cannot recognize long-term capital gains, the long-term capital losses simply become a useless asset to the taxpayer. Also the tax liability of the liquidated corporation should have been less under the majority’s view because of the deductions, but the statute of limitations had no doubt run.
3. Two policies came into conflict in Arrowsmith. The Tax Court and Justice Jackson bought into the annual accounting principle. The other principle that permeates the Code is that a taxpayer may not change the character of income or loss – whether capital or ordinary. This is a very strong policy that only rarely loses to another policy. Often times, taxpayers’ machinations are much more deliberate than they were in this case.