Tax Lawyer's Blog

The United States Supreme Court has issued hundreds of important tax decisions since Congress’ enactment of the Income Tax in 1913. But which of these cases have had the most lasting impact on taxpayers and tax professionals?

Here are my top five:

1. Burnet v. Logan (1931) – The open transaction doctrine.

The taxpayer sold stock in a steel company that operated a mine under a long-term lease through a subsidiary. The lease did not require minimum or maximum production tonnage or any definite payments. In return for the stock, the taxpayer received cash plus an obligation to annually receive a certain sum for each ton of ore that the buyer mined. The government established a value for the obligation, treated the transaction as “closed” on the sale date, and required the gain to be estimated and taxed currently.

The taxpayer did not consider the obligation to make future payments as one with an ascertainable fair market value and, thus, treated amounts received as nontaxable returns of capital until the stock basis was fully recovered.

As annual payments on account of extracted ore come in they can be readily apportioned first as return of capital and later as profit. The liability for income tax ultimately can be fairly determined without resort to mere estimates, assumptions and speculation. When the profit, if any, is actually realized, the taxpayer will be required to respond. The consideration for the sale was $2,200,000.00 in cash and the promise of future money payments wholly contingent upon facts and circumstances not possible to foretell with anything like fair certainty. The promise was in no proper sense equivalent to cash. It had no ascertainable fair market value. The transaction was not a closed one. Respondent might never recoup her capital investment from payments only conditionally promised.

Since Burnet v. Logan, the IRS and and the Courts have ruled that only in extreme circumstances will property be deemed to lack an ascertainable fair market value. See McShain v. Commissioner 71 T.C. 998; Treasury Regulation Section 1.1001-1(a); and Rev. Rul. 58-402, 1958-2 C.B. 15.

2. INDOPCO v. Commissioner of Internal Revenue (1992)  - Costs that result in “significant future benefit” must be capitalized.

The Court held that $2.75M in investment banking fees (incurred by a target corporation in connection with its friendly acquisition) must be capitalized. The Court reasoned that capitalization was required because the fees could be expected to produce a “significant future benefit” once the acquisition was consummated.

Here’s how Leonard Weld and Charles Price described the case for The CPA Journal:

INDOPCO clarified the capitalization rule established in Lincoln Savings & Loan Assn (71-1 USTC 9476). In Lincoln, the U.S. Supreme Court stated that if an expenditure creates or enhances “a separate and distinct asset” that expenditure must be capitalized. In the Supreme Court held that creation of a separate asset is a sufficient, but not necessary, condition to require capitalization of an expenditure.

The costs in dispute in INDOPCO were for legal and other professional fees incurred by a target corporation in the course of a friendly takeover. Since a separate and distinct asset was not created, the taxpayer wanted to expense the costs. The court ruled that any costs that result in significant future benefits accruing to the taxpayer are capital in nature and not immediately deductible. This “future benefit” doctrine immediately caused taxpayers to question whether all costs that obviously result in future benefits (e.g., training, advertising, and downsizing costs) must be capitalized. At first, the IRS was fairly lenient about using the new future benefit doctrine; however, recent disputes show that the IRS is becoming more aggressive.

And here’s what George White said about the impact of INDOPCO in an article he wrote for the American Institute of Certified Public Accountants: 

Instead of taxpayer capitulation, what the Government reaped was a decade of controversy with taxpayers resisting the unrealistic “significant future benefit” standard of INDOPCO.  By 2001, Treasury was ready to throw in the towel, conceding that fully 25% of the IRS’s examination resources were being consumed by INDOPCO issues.

The Treasury Department has since capitulated and has issued taxpayer-favorable regulations that govern when expenses must be capitalized.

3. U.S. v. Kirby Lumber (1931) - Debt forgiveness/cancellation is taxable income.

In 1923, Kirby Lumber Company, issued its own bonds for $12,126,800 for which it received their par value. Later in the same year it purchased in the open market some of the same bonds at less than par, the difference of price being $137,521.30. The question before the Court was whether this difference was a taxable gain or income of the plaintiff for the year 1923.

Justice Oliver Wendall Holmes, Jr. delivered the opinion:

. . . there was no shrinkage of assets and the taxpayer made a clear gain. As a result of its dealings it made available $137,521.30 assets previously offset by the obligation of bonds now extinct. We see nothing to be gained by the discussion of judicial definitions. The defendant in error has realized within the year an accession to income . . . . 

4. Crane v. Commissioner (1947)  - Debt assumed by the buyer is the equivalent of money received by the seller.

According to ubiquitous tax author and academician, Boris I. Bittker, this case “laid the foundation stone of most tax shelters.”  

Crane was the sole beneficiary and executrix of her husband’s estate. She inherited an apartment building and land that secured a debt of $255,000. The property was valued for estate tax purposes at a value equal to the mortgage encumbrance. Several years later the property was sold for $3,000 subject to the mortgage. Crane reported $2,500 of taxable gain from the sale of the apartment (she incurred $500 in expenses to complete the sale).

The Court determined that a mortgagor who transfers a property subject to the mortgage benefits as if the purchaser had paid the mortgage on the property.

This case created the tax law doctrine that a seller of property receives a taxable gain in the amount of any debt assumed by the purchaser. Thus, when property encumbered by debt is sold, the tax consequences of the assumption or transfer of the debt have a significant effect on the overall tax consequences of the sale. In this case Crane, who sold an apartment building for $3,000, had to recognize taxable income of $24,000.

5. Lucas v. Earl (1930) - The substance rather than the form of a transaction controls its tax treatment.

A husband entered into a contract with his wife to assign half his wages to her and then reported the other half of his wages as income on his tax return. Even though the contract was found to be a valid and enforceable one, Justice Holmes said that you cannot change the substance of a transaction by altering its form:

[N]o doubt that the statute required salaries to be taxed by those who earned them and provided that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. . . . The fruits cannot be attributed to a different tree from that on which they grew.

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