What Is Gross Income: Section 61 and the Sixteenth Amendment

We now consider elements of the tax formula. You should place whatever topics we study (the “trees”) within that formula (the “forest”). This chapter introduces you to the concept of “gross income,” the very first item in the tax formula. We also consider the constitutional underpinning of the federal income tax. The constitutional basis of the income tax has been intertwined with the concept of gross income itself. That is because, as courts frequently observe, Congress exercised all the authority to tax income that the Sixteenth Amendment gave it.

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

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

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

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

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

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

The Constitution does not delegate to any other branch of the government any authority to impose taxes.

In Article I, § 9, cl. 4, the Constitution refers to “direct” taxes, and restricts them to impositions upon states according to their population. The founding fathers regarded consumption taxes as “indirect taxes” and regarded them as superior to “direct taxes” in terms of fairness and for purposes of raising revenue. See Alexander Hamilton, Federalist No. 21. An income tax is a “direct tax.” Pollock v. Farmers’ Loan & Trust Co., 158 U.S. 601, 630 (1895) (tax on income from property). Congress has never tried to assess an income tax state by state in proportion to their respective populations. Hence, imposition of an income tax required an amendment to the Constitution. That came in 1913:

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

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

We consider here two cases in which the Supreme Court undertook to provide a definition of “gross income,” the phrase that Congress used in § 61(a). We then consider a case in which the United States Court of Appeals for the Seventh Circuit considered the scope of congressional authority to impose an income tax. In Macomber, notice the justices’ differing views on the internal accounting of a corporation.

• What does the Court mean by “capitalization?”

• What does the Court mean by “surplus?”

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

MR. JUSTICE PITNEY delivered the opinion of the Court.

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

The facts, in outline, are as follows:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Judgment affirmed.

Mr. Justice Holmes, dissenting. [omitted]

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

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

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

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

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

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

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

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

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

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

Fourth. …

Fifth. …

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

Notes and Questions:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

….

Reversed.

Mr. Justice DOUGLAS dissents. …

Notes and Questions:

1. Taxpayers acknowledged that Congress could constitutionally impose a tax on punitive damages. Interestingly, the Supreme Court has indeed observed many times that Congress exercised all the power granted it by the Sixteenth Amendment. How much room does this really leave for a taxpayer to argue that Congress could tax windfalls but had not? Taxpayer may still argue that it’s not income, and there is no other tax on punitive damages.

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

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

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

5. The following case provides a good primer (review) of Congress’s constitutional power to tax.

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

On Rehearing

GINSBURG, Chief Judge:

….

I. Background

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

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

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

II. Analysis

….

B. Section 104(a)(2) of the IRC

Section 104(a) (“Compensation for injuries or sickness”) provides that “gross income [under § 61 of the IRC] does not include the amount of any damages (other than punitive damages) received … on account of personal physical injuries or physical sickness.” 26 U.S.C. § 104(a)(2). Since 1996 it has further provided that, for purposes of this exclusion, “emotional distress shall not be treated as a physical injury or physical sickness.” Id. § 104(a). …

….

… In O’Gilvie v. United States, 519 U.S. 79 (1996), the Supreme Court read [the phrase “on account of”] to require a “strong[ ] causal connection,” thereby making § 104(a)(2) “applicable only to those personal injury lawsuit damages that were awarded by reason of, or because of, the personal injuries.” The Court specifically rejected a “but-for” formulation in favor of a “stronger causal connection.” …

….

C. Section 61 of the IRC

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

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

….

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

The Government disputes Murphy’s interpretation on all fronts. First, noting “the definition [of gross income in the IRC] extends broadly to all economic gains,” Banks, 543 U.S. at 433, the Government asserts Murphy “undeniably had economic gain because she was better off financially after receiving the damages award than she was prior to receiving it.” Second, the Government argues that the case law Murphy cites does not support the proposition that the Congress lacks the power to tax as income recoveries for personal injuries. …

….

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

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

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

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

….

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

D. The Congress’s Power to Tax

1. A Direct Tax?

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

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

… As it is clear that Murphy cannot shift her tax burden to anyone else, per Murphy and the amici, it must be a direct tax.

….

… As the Government interprets the historical record, the apportionment limitation was “more symbolic than anything else: it appeased the anti-slavery sentiment of the North and offered a practical advantage to the South as long as the scope of direct taxes was limited.” See Ackerman, supra, at 10. But see Erik M. Jensen, Taxation and the Constitution: How to Read the Direct Tax Clauses, 15 J.L. & Pol. 687, 704 (1999) (“One of the reasons [the direct tax restriction] worked as a compromise was that it had teeth – it made direct taxes difficult to impose – and it had teeth however slaves were counted”).

….

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

….

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

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

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

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

2. Uniformity

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

III. Conclusion

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

Affirmed.

Notes and Questions:

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

2. In the first paragraph of part IIC, the court states our second guiding principle (see chapter 1) of tax law: “There are exceptions to [the principle that we tax all of the income of a particular taxpayer once], but we usually must find those exceptions in the Code itself.”

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

• In National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012), the Supreme Court held:

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

Id. at 571.

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

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

• Items subject to an indirect tax affect the amount of items subject to a direct tax.

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

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

7. The court cited the case of Penn Mut. Indem. Co. v. Comm’r, 277 F.2d 16, 20 (3d Cir. 1960) with this parenthetical: “Congress has the power to impose taxes generally, and if the particular imposition does not run afoul of any constitutional restrictions then the tax is lawful, call it what you will.”

In National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012), the Supreme Court “confirmed” a “functional approach” to whether an assessment is a tax. 567 U.S. at 563-66 (“shared responsibility payment” actually a “tax,” even though called a “penalty”).

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

• Are these positions inconsistent?

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

A. Some Recurring Themes

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

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

….

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

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

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

….

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

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

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

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

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

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

….

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

….

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

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

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

Separate opinion of MR. JUSTICE McREYNOLDS [omitted].

Notes and Questions:

1. Taxpayers pay their federal income taxes from after-tax income. This was not always true. Act of Oct. 3, 1913, entitled “An act to reduce tariff duties and to provide revenue for the Government and for other purposes,” part IIB, granted a deduction for national taxes paid. After Congress repealed this deduction, the American Woolen Company began paying William Wood’s federal income taxes. Without a deduction, taxpayer pays income taxes from after-tax income.

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

3. A taxpayer’s wealth increases when someone else pays one of taxpayer’s obligations. We treat this as an accession to wealth. You will encounter this principle may times throughout this course. Thus, when taxpayer’s employer pays taxpayer’s federal income taxes, taxpayer should include the amount of taxes in his gross income. The principle is applicable in many contexts.

4. A key consideration is whether a third party makes a payment to satisfy an actual “obligation” of the taxpayer, or merely to “restore” to taxpayer “capital” wrongfully or erroneously taken from him. See Clark infra.

Opinion. LEECH.

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

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

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

….

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

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

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

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

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

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

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

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

….

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

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

Decision will be entered for the petitioner.

Notes and Questions:

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

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

3. In Murphy, supra, taxpayer made a “return-of-capital” argument. Why did taxpayer in Murphy lose but the taxpayer in Clark win?

THORNBERRY, Circuit Judge.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Affirmed in part; reversed in part.

JOHN R. BROWN, Chief Judge (concurring):

…

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

Notes and Questions:

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

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

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

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

• What happened to our second principle (see chapter 1) – that all income is taxed once unless an exception is specifically found in the Code?

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

• Does Judge Brown’s analysis support his conclusion?

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

7. Back to windfalls, plus some dumb luck …

YOUNG, District Judge.

….

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

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

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

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

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

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

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

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

Rev. Rul. 61, 1953-1, Cum. Bull. 17.

….

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

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

‘§ 1.61-14 Miscellaneous items of gross income.

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

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

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

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

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

Notes and Questions:

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

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

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

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

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

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

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

MR. JUSTICE MURPHY delivered the opinion of the Court.

….

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

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

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

….

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

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

….

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

The judgment of the Circuit Court of Appeals is affirmed.

Notes and Questions:

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

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

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

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

• What exactly was taxpayer’s basis in his lessor’s interest in the stream of payments to be recognized under the lease? Where would his basis come from?

3. Sections 61(a) lists several forms that gross income may take. One such form is income from discharge of indebtedness. § 61(a)(11). The Code does not treat all forms of gross income the same. Different rates of tax may apply to different forms of gross income. Or, the Code might not – in certain circumstances – tax some forms of gross income at all. This was a key point in Murphy v. IRS, supra, which turned on the construction of § 104. These points preclude us from treating all gross income as a big hodge-podge of money. In the following case, the court distinguishes between a gain that taxpayer derived from dealings in property and gains that taxpayer derived from a discharge of his debt. Determine what was at issue in Gehl, what the parties argued, and why it mattered.

NOTICE: THIS IS AN UNPUBLISHED OPINION.

….

BOGUE, Senior District Judge.

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

BACKGROUND

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

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

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

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

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

DISCUSSION

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

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

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

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

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

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

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

(2) Discharge of indebtedness. The amount realized on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be if realized and recognized) income from the discharge of indebtedness under section [61(a)(11)]. * * *

(c) Examples * * *

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

CONCLUSION

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

Notes and Questions:

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

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

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

I.R.C. §§ 61(a)(3), 1001(a).

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

4. Why is relief from a liability included in amount realized when applying the formula of § 1001?

C. Barter

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

Rev. Rul. 79-24, 1979-1 C.B. 60

GROSS INCOME; BARTER TRANSACTIONS

….

FACTS

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

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

LAW

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

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

HOLDINGS

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

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

Notes and Questions:

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

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

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

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

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

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

3. Read Reg. § 1.61-2(d)(1 and 2(i)).

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

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

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

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

D. Improvements to Leaseholds and the Time Value of Money

MR. JUSTICE ROBERTS delivered the opinion of the Court.

….

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

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

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

….

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

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

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

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

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

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

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

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

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

….

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

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

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

Judgment reversed.

….

Notes and Questions:

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

2. Bruun of course undercuts the language of Eisner v. Macomber concerning the need to sever the improvement (increase in value) from the whole. You can see in taxpayer’s (respondent’s) contentions the elements of the Macomber Court’s definition of “income” (i.e., this was not gain derived from capital). And of course, “realization” does not require receipt of cash.

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

4. Sections 109/1019 reverse the holding of Bruun. Section 109 provides that a lessor of real taxpayer does not realize taxable gross income attributable to improvements that the lessee made to the real property upon termination of the lease. Section 1019 provides that taxpayer may not increase or decrease his adjusted basis in property because he received gross income that § 109 excludes.

• Is § 1019 necessary?

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

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

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

• What is lessor’s basis in the fixtures?

• Exactly what does the payment of rent purchase?

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

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

• Let’s assume that the lessee did not remove a building, but simply erected a new building on vacant premises. Let’s also put some numbers and dates into the problem for illustrative purposes. Assume that the fmv of the building in 2000 upon completion is $400,000. The building will last 40 years. The building will lose $10,000 of value every year, and this is the amount that taxpayer may claim as a depreciation/cost recovery deduction. Taxpayer must reduce his basis in the property (§ 1016) for depreciation deductions. The adjusted basis of the property equals its fmv. The lease upon completion of the building will run another 20 years until 2020. The lessee did not default thereby causing early termination of the lease. Immediately upon termination of the lease, taxpayer sells the property, and the portion of the selling price attributable to the building is $200,000. Taxpayer’s marginal tax bracket is 30%.

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

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

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

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

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

• What is taxpayer’s total tax bill?

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

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

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

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

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

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

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

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

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

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

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

• What is taxpayer’s total tax bill?

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

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

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

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

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

• What is taxpayer’s total tax bill?

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

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

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

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

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

• What is taxpayer’s total tax bill?

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

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

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

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

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

• What is taxpayer’s total tax bill?

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

7. It is very expensive to litigate a case to a federal circuit court of appeals or all the way to the United States Supreme Court. If taxpayer’s total net tax liability under any of the five approaches that the Court identified in Bruun is the same, why would parties spend serious money litigating a choice of rule question to the Supreme Court? For that matter, why would the Treasury Department use up so much ink promulgating and then changing regulations?

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

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

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

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

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

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

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

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

• A useful approximation that you can verify by referring to table 1 is the so-called rule of 72. Simply divide 72 by the interest rate expressed as a whole number, e.g., 6 rather than 6%. The quotient is very close to the length of time it takes money to double in value at that interest rate.