Character of Income and Computation of Tax

Recall that there are three principles of income taxation that the Code implements. See chapter 1. The first of these principles is that “[w]e tax income of a particular taxpayer once and only once.” Section 63(a) defines “taxable income.” In this chapter, we refine the notion of taxing all income once by adding this caveat: for a non-corporate taxpayer, not all income is taxed the same. “Taxable income” has a “character” that determines the tax burden to which it is subject. Under § 1(h), an individual’s tax liability is the sum of the taxes at different rates on income of different characters.

We consider here incomes of the following characters: capital gain – both long-term and short-term, depreciation recapture, § 1231 gain, dividends, and passive. What remains is “ordinary income.” See § 64. “Taxable income” is subject to the tax rates of § 1(a to e), except for tax years 2018 to 2025 when it is subject to the tax rates of § 1(j)(2)(A to E). Income with certain characters is subject to lower maximum rates. We usually refer to the “taxable income” subject to the rates of § 1(a to e) or to § 1(j)(2)(A to E) as “ordinary income,” as opposed to income whose character is such that it is subject to tax at lower “maximum” rates.

Section § 61(a)(3) includes within the scope of “gross income” “gains derived from dealings in property.” Section 1001(a) informed us that taxpayer measures such gains (and losses) by subtracting “adjusted basis” from “amount realized.” Individual taxpayers’ gains from the sale or exchange of “capital assets” might be subject to maximum tax rates lower than those otherwise applicable to “taxable income.” Hence it is important to know what is a “capital asset.”

A. “Capital Asset:” Property Held by the Taxpayer

Read § 1221(a). Notice the structure of the definition, i.e., all property except … Do not the first two lines of this section imply that “capital asset” is a broad concept? Is there a common theme to the exceptions – at least to some of them?

Admittedly, [taxpayer’s] corn futures do not come within the literal language of the exclusions set out in that section. They were not stock in trade, actual inventory, property held for sale to customers or depreciable property used in a trade or business. But the capital-asset provision … must not be so broadly applied as to defeat rather than further the purpose of Congress. [citation omitted]. Congress intended that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss. The [Code’s] preferential treatment [of capital gains] applies to transactions in property which are not the normal source of business income. It was intended ‘to relieve the taxpayer from *** excessive tax burdens on gains resulting from a conversion of capital investments, and to remove the deterrent effect of those burdens on such conversions.’ [citation omitted]. Since this section is an exception from the normal tax requirements of the Internal Revenue Code, the definition of a capital asset must be narrowly applied and its exclusions interpreted broadly. This is necessary to effectuate the basic congressional purpose.

Id. at 51-52.

Congress later amended § 1221 by adding what is now § 1221(a)(7). A “capital asset” does not include “any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into …”

In other cases, taxpayers successfully argued that a futures transaction that proved profitable involved a “capital asset,” whereas a futures transaction that proved unprofitable was a hedge against price fluctuations in a commodity that was definitionally not a “capital asset.” Losses from the sale of non-capital assets could offset ordinary income. This “head-I-win-tails-you-lose” whipsaw of the Commissioner should have ended with the holding in Corn Products. The Commissioner won in Corn Products. Should the Commissioner be happy about that? Do you think that hedge transactions of the sort described in Corn Products more often produce profit or loss?

• The statutory embodiment of the Corn Products rule creates the presumption that a hedge is a capital asset transaction unless the taxpayer identifies it as an “ordinary income transaction” at the time taxpayer enters the transaction. How does this scheme prevent the whipsaw of the Commissioner?

Corn Products is important for its statements concerning how to construe § 1221. While the structure of § 1221 implies that “capital asset” is a broad concept, i.e., “all property except …”, the Court stated that the exceptions were to be construed broadly – thereby eroding the scope of the phrase “capital asset.” Furthermore, we might surmise that a major point of Corn Products is that a transaction that is a “surrogate” for a “non-capital” transaction is in fact a non-capital transaction.

In Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), taxpayer was a diversified holding company that purchased approximately 65% of the stock of a Dallas bank. The bank needed more capital and so over the course of five years, taxpayer tripled its investment in the bank without increasing its percentage interest. During that time, the financial health of the bank declined significantly. Taxpayer sold the bulk of its stock, retaining only a 14.7% interest. It claimed an ordinary loss on the sale of this stock, arguing that its ownership of the stock was for business purposes rather than investment purposes. The Commissioner argued that the loss was a capital loss. Taxpayer argued that Corn Products supported the position that property purchased with a business motive was not a capital asset. The Tax Court agreed with this analysis and applied it to the individual blocks of stock that taxpayer had purchased, evidently finding that there were different motivations for the different purchases. The United States Court of Appeals for the Eighth Circuit reversed, finding that the bank stock was clearly a capital asset. The Supreme Court affirmed. The Court refused to define “capital asset” so as to exclude all assets purchased for a business purpose. “The broad definition of the term ‘capital asset’ explicitly makes irrelevant any consideration of the property’s connection with the taxpayer’s business …” Id. at 217. The Court held that the list of exceptions to § 1221’s broad definition of “capital asset” is exclusive. Id. at 217-18. Instead of defining “capital asset” narrowly as in Corn Products, the Court can broadly construe the inventory exception. Id. at 220. The corn futures in Corn Products were surrogates for inventory.

• Thus, “capital asset” is indeed “all property” except for the items – broadly defined – specifically named in § 1221(a).

• Read § 1221(a)’s list of exceptions to “capital assets” again. Is (are) there a general theme(s) to these exceptions?

• Read again the excerpt from Corn Products, above.

• The phrase “capital asset” includes personal use property. Thus, if a taxpayer sells his personal automobile for a gain, the gain is subject to tax as capital gain.

Do the CALI Lesson, Basic Federal Income Taxation: Property Transactions: Capital Asset Identification.

B. Section 1222: Definitions of Terms Relating to Capital Gains and Losses: Long Term and Short Term Gains and Losses

• short-term capital gain (STCG);

• short-term capital loss (STCL);

• long-term capital gain (LTCG);

• long-term capital loss (LTCL).

Sections 1222(5, 6, 7, and 8) direct us to net all short-term transactions and to net all long-term transactions.

• net short-term capital gain (NSTCG) = STCG – STCL, but not less than zero;

• net short-term capital loss (NSTCL) = STCL – STCG, but not less than zero;

• net long-term capital gain (NLTCG) = LTCG – LTCL, but not less than zero;

• net long-term capital loss (NLTCL) = LTCL – LTCG, but not less than zero.

Notice the precise phrasing of §§ 1222(9, 10, and 11). The definitions of these phrases are in § 1222, but other code sections assign specific tax consequences to them. Section 1222(11) defines “net capital gain” (NCG) to be

NLTCG – NSTCL

Section 1222(9) defines “capital gain net income” to be all capital gain, no matter its character, minus all capital loss, no matter its character.

We defer for the moment the definition of “net capital loss” to the discussion of capital loss carryovers.

Notice that the definitions of § 1222 implement, at least initially, a matching principle to gains and losses. Short-term losses offset only short-term gains. Long-term losses offset only long-term gains.

In determining NCG, net short-term capital loss offsets net long-term capital gain. Section 1222 does not allow any other mismatching. (Section 1211(b) allows some limited mismatching.) The matching principle is very important to individual taxpayers because only the LTCG that remains after allowable offsets (LTCL and NSTCL) is subject to tax at reduced maximum rates; other income is subject to tax at otherwise higher “ordinary income” rates.

Do the CALI Lesson, Basic Federal Income Taxation: Property Transactions: Capital Gain Mechanics (For questions on “capital gain net income,” see § 1222(9)).

C. Deductibility of Capital Losses and Capital Loss Carryforwards

In the event taxpayer incurred losses greater than those allowed by § 1211(b), i.e., a “net capital loss,” § 1222(10), taxpayer may carry them forward until he dies. § 1212(b). Section 1212(b) treats a capital loss-carryover as if it were one of the transactions described in §§ 1222(2 or 4) (i.e., STCL or LTCL) in the next succeeding year.

• If the “net capital loss” results from both NLTCL and NSTCL, then taxpayer first reduces the NSTCL by the amount of his § 1211(b) deduction, and then reduces the NLTCL by the balance (if any) of his § 1211(b) deduction. Taxpayer separately carries forward the remaining NSTCL and NLTCL.

• If NSTCL > NLTCG, then taxpayer carries forward the “net capital loss” as a STCL transaction. § 1212(b)(1)(A) and § 1212(b)(2)(A).

• If NLTCL > NSTCG, then taxpayer carries forward the “net capital loss” as a LTCL transaction. §§ 1212(b)(1)(B) and 1212(b)(2)(A).

Example 1: Taxpayer has $100,000 of “taxable income” derived from wages. For the tax year, taxpayer also has $5000 of NSTCL and $4000 of NLTCL. What is taxpayer’s § 1211(b) deduction, and what is taxpayer’s § 1212(b) capital loss carryover?

• Taxpayer’s capital losses (i.e., $9000) exceed his capital gains (i.e., $0) by $9000. Taxpayer’s § 1211(b) deduction is $3000. He may deduct $3000 against his “taxable income” derived from wages. Taxpayer’s has a “net capital loss” (§ 1222(10)), which is $6000.

Example 2. Taxpayer has $100,000 of “taxable income” derived from wages. For the year, taxpayer also has $8000 of NSTCL and $2000 of NLTCG.

• Taxpayer’s capital losses exceed his capital gains by $6000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s has a “net capital loss” of $3000.

Example 3. Taxpayer has $100,000 of “taxable income” derived from wages. For the year, taxpayer also has $11,000 of NSTCG and $18,000 of NLTCL.

• Taxpayer’s capital losses exceed his capital gains by $7000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer has a “net capital loss” of $4000.

• We calculate taxpayer’s capital loss carryover by first adding $3000 to his NSTCG. Taxpayer’s NSTCG becomes $14,000. Subtract $14,000 from $18,000. Taxpayer will carry forward $4000 as a LTCL to the succeeding year. § 1212(b)(1)(B).

Do the CALI Lesson, Basic Federal Income Taxation: Property Transactions: Capital Loss Mechanics.

D. Computation of Tax

The next “basket” is “unrecaptured § 1250 gain.” Section 1(h)(1)(E) subjects unrecaptured depreciation on real property up to the amount of net § 1231 gain (infra) to a maximum rate of 25%.

The last basket is “28-percent rate gain.” Section 1(h)(1)(F) subjects “28-percent rate gain” property to a maximum rate of (surprise) 28%. § 1(h)(1)(E).

Taxpayer’s tax liability is the sum of the taxes imposed on these income baskets.

The basis of an allowance for depreciation is the notion that during a tax year a taxpayer consumes a portion, but only a portion, of an asset that enables him to generate income over a period longer than one year. The Code treats that bit of “consumption” the same as any other consumption that enables a taxpayer to generate income, i.e., a deduction from ordinary income. See §§ 162, 212. Such an allowance requires an equal reduction in taxpayer’s basis in the asset. See § 1016(a)(2).

A. Section 1245

• A property’s “recomputed basis” is its adjusted basis plus all “adjustments reflected in such adjusted basis on account of deductions (whether in respect of the same or other property) allowed or allowable to the taxpayer or to any other person for depreciation or amortization.” § 1245(a)(2)(A).

• Taxpayer may establish “by adequate records or other sufficient evidence” that the amount allowed for depreciation or amortization was less than the amount allowable. § 1245(a)(2)(B).

• Deductions allowed by provisions other than § 167 and § 168 – notably expensing provisions that reduce taxpayer’s basis in the property – are also considered to be “amortization,” § 1245(a)(2)(C), and so become a part of the property’s “recomputed basis.”

“Section 1245 property” is property that is subject to an allowance for depreciation under § 167 (which of course includes § 168) and is –

• personal property, § 1245(a)(3)(A),

• other tangible property – not including a building or structural components – that was used as an “integral part of manufacturing, production, or extraction or of furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services,” § 1245(a)(3)(B)(i), that constituted a research facility in connection with these activities, § 1245(a)(3)(B)(ii), or that constituted a facility used in connection with such activities for the bulk storage of fungible commodities, § 1245(a)(3)(B)(iii),

• real property subject to depreciation and whose basis reflects the benefit of certain special or rapid depreciation provisions, § 1245(a)(3)(C),

• a “single purpose agricultural or horticultural structure,” § 1245(a)(3)(D),

• a “storage facility (not including a building or its structural components) used in connection with the distribution of petroleum” products, § 1245(a)(3)(E), or

• a “railroad grading or tunnel bore,” § 1245(a)(3)(F).

Example:

• Taxpayer is a professional violinist who plays the violin for the local symphony orchestra. She purchased a violin bow for $100,000 in May 2017. Treat a violin bow as 7-year property. In January 2019, she sold the bow for $110,000, its fmv. What is the taxable gain on which taxpayer must pay tax and what is the character of that gain?

• Taxpayer will deduct a cost recovery allowance under § 168. She will apply the half-year convention to both the year in which she placed the bow in service and the year of sale. § 168(d)(4).

• Go to the tables at the front of your Code. In 2017, she will deduct 14.29% of $100,000, or $14,290. In 2018 she will deduct 24.49% of $100,000, or $24,490. In 2019, she will deduct half of 17.49% of $100,000, or $8745.

• Taxpayer’s remaining basis in the violin bow is $52,475.

• Taxpayer’s “recomputed basis” is $100,000. It is less than the fmv of the bow. Hence, taxpayer has depreciation recapture income of $47,525. This is ordinary income. The balance of taxpayer’s gain (i.e., $10,000) is § 1231 gain, infra, which will be subject to tax as if it were long term capital gain.

• Suppose that taxpayer sold the violin bow for its fmv of $90,000.

• Now the fmv of the bow is less than taxpayer’s recomputed basis.

• Hence, taxpayer’s depreciation recapture income is $37,525. This income is subject to tax as ordinary income.

Section 1245 provides specific rules governing certain dispositions.

• Section 1245 does not apply to a disposition by gift. § 1245(b)(1). Instead, the donee takes the donor’s basis for purposes of determining gain – and includes recapture income in his income upon disposition of the gifted property.

• Section 1245 does not apply to a transfer at death. § 1245(b)(2). Since there is a basis step-up on property acquired from a decedent, § 1014(a), depreciation recapture is not subject to tax at all upon such a disposition.

• In certain tax-free dispositions of property between a subsidiary and its parent corporation, shareholders and a corporation, and partners and a partnership – there is no recognition of depreciation recapture. § 1245(b)(3). Instead, the recipient – who takes a carryover basis – will recognize depreciation recapture income upon disposition of the property.

• In a tax-deferred like-kind exchange (§ 1031) or involuntary conversion (§ 1033), depreciation recapture is subject to tax only to the extent the acquisition of property not qualifying for tax-deferred treatment is subject to tax plus the fmv of non-section 1245 property acquired. § 1245(b)(4). Instead gain on the disposition of the replacement property attributable to depreciation allowances on both the original and the replacement properties is depreciation recapture income.

• Section 1245 does not apply to a tax-deferred distribution of partnership property to a partner. § 1245(b)(5)(A). The partner will recognize depreciation recapture income upon his disposition of the property (subject to some very technical adjustments).

• Section 1245 does not apply to a disposition to a tax-exempt organization, § 1245(b)(3), unless the organization immediately uses the property in a trade or business unrelated to its exemption, § 1245(b)(6)(A). If the tax-exempt organization later ceases to use the property for a purpose related to its exemption, it is treated as having made a disposition on the date of such cessation. § 1245(b)(6)(B).

• Special amortization rules apply to reforestation expenditures. § 194. An 84-month amortization period applies. § 194(a)(1). Ten years after acquiring the “amortizable basis” for incurring reforestation expenditures, gain on the disposition of such assets is no longer considered to be depreciation recapture. § 1245(b)(7).

• If taxpayer disposes of more than one amortizable section 197 intangible in one or more related transactions, all section 197 intangibles are considered to be one section 1245 property. § 1245(b)(8)(A). However, this rule does not apply to a section 197 intangible whose fmv is less than its adjusted basis. § 1245(b)(8)(B).

Section 1245(d) provides that § 1245 applies “notwithstanding any other provision of this subtitle.” This means that except to the extent § 1245 itself excepts its own applicability, depreciation recapture will be carved out of the gain on any disposition of depreciable or amortizable property and be subject to tax as ordinary income. This important provision limits taxpayer opportunity to mismatch the character of income against which he claims deductions with the character of subsequent resulting gain.

B. Section 1250

Section 1250 treats as ordinary income, § 1250(a)(1)(A), the recapture of so-called “additional depreciation,” i.e., the excess of depreciation adjustments over straight-line adjustments on “section 1250 property” held for more than one year. § 1250(b)(1). Section 1250 property is real property to which § 1245 does not apply. Since § 168 allowances on real property are all now straight-line, the applicability of § 1250 is limited.

Nevertheless, depreciation allowances on real property are recaptured for individual taxpayers to an extent through the (complicated) interplay of § 1(h)(6) (supra) and § 1231 (infra).

During World War II, the nation moved to a war economy. The Government seized many of the nation’s productive assets to convert them to production of items critical to the war effort. The Fifth Amendment to the Constitution of course requires that the owners of such properties be justly compensated. The owners of businesses often did not wish to sell their assets to the Government and then to pay income tax (at wartime rates) on the taxable gains they were forced to recognize. Congress responded by enacting § 1231 – a sort of “heads-I-win-tails-you-lose” measure for taxpayers who found themselves with (substantial amounts of) unplanned-for taxable income. Basically, net gains from such transactions would be treated as capital gains; net losses from such transactions would be treated as ordinary losses. Don’t forget that corporations still enjoyed a capital gains rate preference. World War II ended a long time ago, but § 1231 is still with us. It has become a very important provision in the sale of a business’s productive assets.

Section 1231 applies to “property used in the trade or business” and to any capital asset held for more than one year in connection with a trade or business or a transaction entered into for profit. § 1231(a)(3). Section 1231(b) defines “property used in the trade or business” essentially as “property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year, and real property used in the trade or business, held for more than 1 year[.]” § 1231(b)(1). Such property is the same as the property that § 1221(a)(2) describes, but which the taxpayer has held for more than one year. Such property does not encompass property that § 1221(a)(1, 3, and 5) describes.

Section 1231 requires two netting processes – both of which adopt the “heads-I-win-tails-you lose” characterization of transactions. If the first netting process yields a gain, the net gain becomes a part of the second netting process. Those who write about § 1231 often describe this in terms of mixing ingredients in two pots. If the mixture in the first pot yields a net positive, it is added to the second pot; otherwise, it is not added. We are talking about non-statutory terms so we can use any terminology we wish – but let’s consider the first netting process to occur in a “firepot.” The second netting process occurs in a “hotchpot.”

Firepot: Section 1231 initially adopts the “heads-I-win-tails-you-lose” principle for “involuntary conversions” resulting from casualty losses of “property used in the trade or business” or of a capital asset held for more than one year in connection with a trade or business or transaction entered into for profit. § 1231(a)(4)(C). If a taxpayer’s gains and losses from such “involuntary conversions” resulting from casualty losses net to a loss, then § 1231 does not apply to any such gains and losses. § 1231(a)(4) (carryout paragraph). Gains/losses from condemnation are not included in the firepot. The upshot of this “inapplicability” is that such gains and losses are treated as realized on the disposition of non-capital assets, so the net loss will be an ordinary loss. If the gains and losses from such transactions yield a net gain or if the net gain (or net loss) is $0, then § 1231 is applicable to them. See Reg. § 1.1231-1(e)(3). Such transactions are added to the § 1231 hotchpot.

Section 1231 Hotchpot: Section 1231 requires a netting of “section 1231 gains” and “section 1231 losses.” “Section 1231 gain” is

• gain recognized on the sale or exchange of “property used in the trade or business” plus

• gain recognized on the compulsory or involuntary conversion into money or other property as a result of whole or partial destruction, theft or seizure, or requisition or condemnation of “property used in the trade or business” or a “capital asset held for more than 1 year” that “is held in connection with a trade or business or a transaction entered into for profit.” § 1231(a)(3)(A).

But –

• Such gain does not include depreciation recapture. § 1245(d), § 1250(h), Reg. § 1.1245-6(a), Reg. § 1.1250-1(e)(1).

“Section 1231 loss” is loss recognized on such sales, exchanges, or conversions – but not, of course, net losses resulting from involuntary conversions resulting from casualties. Compare § 1231((a)(3)(A)(ii) with § 1231(a)(4)(C).

Section 1231(a)(1 and 2) implements the “heads-I-win-tails-you-lose” principle.

• If section 1231 gains for any taxable year exceed section 1231 losses, such gains and losses are treated as LTCG or LTCL as the case may be. § 1231(a)(1).

A provision so taxpayer-friendly would be subject to some abuse. With only a little planning, a taxpayer may dispose of section 1231 “winners” in one taxable year and section 1231 “losers” in a different taxable year. Hence, § 1231(c) creates a so-called “5-year lookback rule.” For any year in which taxpayer recognizes net section 1231 gains, such gains are taxed as ordinary income to the extent taxpayer recognized section 1231 losses during the five most recent preceding taxable years. § 1231(c).

Do the CALI Lesson, Basic Federal Income Taxation: Property Transactions: Identification of Section 1231 Property.

Do the CALI Lesson, Basic Federal Income Taxation: Property Transactions: Section 1231 Mechanics.

The following materials should make the point that matching income and expenses with respect to character is more than simply the rule of some Code sections: it is a bedrock principle that pervades construction of the Code.

MR. JUSTICE BLACK delivered the opinion of the Court.

This is an income tax controversy growing out of the following facts … In 1937, two taxpayers, petitioners here, decided to liquidate and divide the proceeds of a corporation in which they had equal stock ownership. Partial distributions made in 1937, 1938, and 1939 were followed by a final one in 1940. Petitioners reported the profits obtained from this transaction, classifying them as capital gains. They thereby paid less income tax than would have been required had the income been attributed to ordinary business transactions for profit. About the propriety of these 1937-1940 returns there is no dispute. But, in 1944, a judgment was rendered against the old corporation and against Frederick R. Bauer, individually. The two taxpayers were required to and did pay the judgment for the corporation, of whose assets they were transferees. [citations omitted]. Classifying the loss as an ordinary business one, each took a tax deduction for 100% of the amount paid. … The Commissioner viewed the 1944 payment as part of the original liquidation transaction requiring classification as a capital loss, just as the taxpayers had treated the original dividends as capital gains. Disagreeing with the Commissioner, the Tax Court classified the 1944 payment as an ordinary business loss. Disagreeing with the Tax Court, the Court of Appeals reversed, treating the loss as “capital.” This latter holding conflicts with the Third Circuit’s holding in Commissioner v. Switlik, 184 F.2d 299. Because of this conflict, we granted certiorari.

I.R.C. § 23(g) [(1222)] treats losses from sales or exchanges of capital assets as “capital losses,” and I.R.C. § 115(c) [(331)] requires that liquidation distributions be treated as exchanges. The losses here fall squarely within the definition of “capital losses” contained in these sections. Taxpayers were required to pay the judgment because of liability imposed on them as transferees of liquidation distribution assets. And it is plain that their liability as transferees was not based on any ordinary business transaction of theirs apart from the liquidation proceedings. It is not even denied that, had this judgment been paid after liquidation, but during the year 1940, the losses would have been properly treated as capital ones. For payment during 1940 would simply have reduced the amount of capital gains taxpayers received during that year.

It is contended, however, that this payment, which would have been a capital transaction in 1940, was transformed into an ordinary business transaction in 1944 because of the well established principle that each taxable year is a separate unit for tax accounting purposes. United States v. Lewis, 340 U.S. 590; North American Oil Consolidated v. Burnet, 286 U.S. 417. But this principle is not breached by considering all the 1937-1944 liquidation transaction events in order properly to classify the nature of the 1944 loss for tax purposes. Such an examination is not an attempt to reopen and readjust the 1937 to 1940 tax returns, an action that would be inconsistent with the annual tax accounting principle.

….

Affirmed.

MR. JUSTICE DOUGLAS, dissenting. [omitted]

MR. JUSTICE JACKSON, whom MR. JUSTICE FRANKFURTER joins, dissenting.

This problem arises only because the judgment was rendered in a taxable year subsequent to the liquidation.

Had the liability of the transferor-corporation been reduced to judgment during the taxable year in which liquidation occurred, or prior thereto this problem under the tax laws, would not arise. The amount of the judgment rendered against the corporation would have decreased the amount it had available for distribution, which would have reduced the liquidating dividends proportionately and diminished the capital gains taxes assessed against the stockholders. Probably it would also have decreased the corporation’s own taxable income.

Congress might have allowed, under such circumstances, tax returns of the prior year to be reopened or readjusted so as to give the same tax results as would have obtained had the liability become known prior to liquidation. Such a solution is foreclosed to us, and the alternatives left are to regard the judgment liability fastened by operation of law on the transferee as an ordinary loss for the year of adjudication or to regard it as a capital loss for such year.

….

I find little aid in the choice of alternatives from arguments based on equities. One enables the taxpayer to deduct the amount of the judgment against his ordinary income which might be taxed as high as 87%, while, if the liability had been assessed against the corporation prior to liquidation, it would have reduced his capital gain which was taxable at only 25% (now 26%). The consequence may readily be characterized as a windfall (regarding a windfall as anything that is left to a taxpayer after the collector has finished with him).

On the other hand, adoption of the contrary alternative may penalize the taxpayer because of two factors: (1) since capital losses are deductible only against capital gains plus $1,000, a taxpayer having no net capital gains in the ensuing five years would have no opportunity to deduct anything beyond $5,000, and, (2) had the liability been discharged by the corporation, a portion of it would probably, in effect, have been paid by the Government, since the corporation could have taken it as a deduction, while here, the total liability comes out of the pockets of the stockholders.

….

Notes and Questions:

1. Upon liquidation of a corporation, the corporation distributes its assets to its shareholders in exchange for their stock. Shareholders treat this as a sale or exchange of a capital asset. § 331(a). Recall from our discussion of Gilliam that payment of a tort judgment would have been an ordinary and necessary business expense, deductible under § 162(a).

2. The opinion of Justice Jackson spells out just what is at stake. First, recognition of capital losses would save taxpayers less than recognition of the same losses as ordinary. Second, capital losses are – except to the narrow extent permitted by § 1211 – only offset by capital gains. If a taxpayer does not or cannot recognize capital gains, the long-term capital losses simply become a useless asset to the taxpayer. Also, the tax liability of the liquidated corporation should have been less under the majority’s view because of the deductions, but the statute of limitations had no doubt run.

3. Two policies came into conflict in Arrowsmith. The Tax Court and Justice Jackson bought into the annual accounting principle. The other principle that permeates the Code is that a taxpayer may not change the character of income or loss – whether capital or ordinary. This is a very strong policy that only rarely yields to another policy. Often, taxpayers’ machinations are much more deliberate than they were in this case.

A. Matching Tax-Exempt Income and Its Costs

Ours is an income tax system that taxes net income. But what if certain income is not subject to tax because it falls within an exception to the first of our three guiding principles? Should the expense of producing such income be deductible? Logically, such expenses should not be deductible – and this is indeed a rule that the Code implements in at least two places.

Section 265 denies deductions for the costs of realizing tax exempt income. Section 264(a)(1) provides that a life insurance contract beneficiary’s premium payment is not deductible. Of course, the life insurance payments made by reason of death are excluded from the beneficiary’s gross income. § 101(a)(1). This same principle generally applies to interest incurred to pay life insurance contract premiums. § 264(a)(4).

B. More Matching: Investment Interest

Section 163(d)(1) limits the interest deduction to interest on indebtedness properly allocable to property held for investment to the extent of taxpayer’s “net investment income … for the taxable year.” Taxpayer may elect to treat his “qualified dividend income,” see § 1(h)(11)(B), as “investment income,” thereby increasing the amount of investment interest he may deduct. § 1(h)(11)(B). Taxpayer may carry forward any investment interest disallowed to the succeeding taxable year. § 163(d)(2). Until 2026, § 67(g) suspends even this deduction.

C. Passive Activities Losses and Credits

A passive activity is a trade or business in which the taxpayer does not “materially participate.” § 469(c)(1). An individual taxpayer may not deduct aggregate passive activity losses in excess of his passive activity income, nor claim credits in excess of the tax attributable to the aggregate of his net income from passive activities. §§ 469(a)(1), 469(d). We defer discussion of the details of § 469 to a course in partnership tax. The important point here is that there is absolutely no mismatching of losses derived from passive activities with any other type of income – whether ordinary income or portfolio (investment) income – until taxpayer has sold all his interests in passive activities.

D. General Comment about Matching Principles

Perhaps it does not seem very significant that implementation of matching principles results in disallowance of a deduction, loss, or credit because usually there is a carryover. Your attitude may be “pick it up next year.” Reality may be quite different. When losses are “locked inside” an activity or type of income, it probably is the case that circumstances are not going to change radically for a taxpayer from one year to the next. The investor who loses a deduction because of insufficient income of a particular type is not likely suddenly to receive a lot of that type of income during the next year. The effect of implementing matching principles may be that the excess expense or loss is simply disallowed – forever. However, forewarned is forearmed. Taxpayers may choose their activities or transactions so that they will have gains against which losses can be matched. The effect of § 67(g), which denies taxpayers “miscellaneous deductions” until 2026, will be to alter taxpayers’ calculus of risk and reward further.

1. What policy (policies) is served by the exceptions to the definition of “capital asset” in §§ 1221(a)(1, 2, 3, 4, 6, 7, 8)?

2. In Fribourg Navigation Co. v. Commissioner, 383 U.S. 272 (1966), the Supreme Court held that a taxpayer was entitled to depreciation deductions up to the date it sold an asset. In the days before § 1245 (but after § 1231), why would this have been important?

3. Why should capital loss carryovers expire – and simply disappear – on the death of the taxpayer?

4. In what ways does § 1031 help facilitate growth within our economy?

5. Why should a taxpayer not be permitted to deduct the cost of obtaining tax-exempt income?

Can you explain or define –

• What is a capital asset? What types of assets are not capital assets?

• Describe how § 1(h) works?

• Describe the netting of LT/ST capital gains/losses that § 1221 prescribes?

• To what extent does § 1211(b) allow an individual taxpayer to offset capital gains (LT or ST) with capital losses (LT or ST)?

• What is depreciation recapture? Why is it needed? What is its effect?

• What is § 1231 property? What tax treatment does the Code provide for the sale or exchange of § 1231 property? In what way(s) does § 1231 implement a “heads-I-win-tails-you-lose” scheme with the taxpayer?

• What is a like-kind exchange? What is the tax treatment of a like-kind exchange?