WEEK 3 RESEARCH PROJECT
(Set #1)
ACCT 429
DeVry University
IMPORTANT NOTE TO STUDENTS
This assignment is being distributed solely for your use in completing the Week 3 project in
DeVry University’s online Accounting 429 class. This assignment is an individual assignment,
and you are to complete it without any outside Helpance by any other student, individual, or
outside materials, other than those specifically permitted by the problem. Any violations of
these requirements will be addressed as an academic integrity violation. Similarly, this
assignment may not be shared with any other student at any time, even after your completion
of the course. Students to do so may be subject to sanctions pursuant to DeVry’s academic
integrity policy, even though they may no longer be enrolled in Accounting 429.
Week 3 Research Project (Set #1)
DeVry University Acct 429
Performing tax research is an important part of tax practice. As outlined in Chapter 2 of your
textbook, tax law is developed through a number of different governmental entities. Congress
enacts the tax Code as statutory law. The Treasury Department is tasked with the
implementation of the tax Code and, in the course of doing so, develops a number of
documents and materials to aid taxpayers in understanding the Treasury Department’s
interpretation of the code, including the Regulations. In turn, the Internal Revenue Service
(“IRS”) has the direct responsibility for implementing the tax Code and in assessing and
collecting the applicable tax from taxpayers. In the course of its duties, it also develops a
number of materials, including Revenue Rulings, Revenue Procedures, and Private Letter
Rulings, in which it sets forth its understanding of the tax laws. Finally, the federal courts
decide tax cases in which taxpayers contest the government’s interpretation of the tax laws. In
deciding these cases, the federal courts set forth binding interpretation of what the tax laws
provide. All of these materials (often called primary resources) are important resources in
performing tax research. On top of these primary sources of tax law, there are a number of
secondary materials provided by various organizations and publishers. These secondary
materials offer editorial analysis of the tax laws (somewhat akin to a Cliffs’ Notes® on tax laws)
to help tax practitioners understand the tax laws and apply them in given situations.
The following assignment has three (3) different graded elements. Two of them require you to
prepare tax file memoranda, while the remaining element requires you to compose an essay
answering the question asked. AS SUCH, YOU WILL BE SUBMITTING THREE SEPARATE
DOCUMENTS FOR THIS ASSIGNMENT.
1. The first two assignments require you to compose tax file memoranda. In each of these
problems, you will be given a fact pattern or issue that requires you to decide or analyze
a particular issue of tax law. You will also be provided with a number of the primary
sources discussed above (e.g., Revenue Rulings, cases) on that issue of tax law. You will
then compose a tax file memoranda concerning that taxpayer. You can find details as to
how to compose such a memorandum in Chapter 2 of your text, including a sample text
file memorandum in Figure 2.6 on page 2-26 of your text. Use the materials provided to
determine the proper solution to the taxpayer’s issues. In particular, discuss the
materials in some detail in the “Analysis” section of the tax file memorandum. THIS IS
IMPORTANT! The most important part of any tax file memorandum is the thoroughness
of the analysis defending the conclusion reached in the memorandum. Accordingly,
most of the points awarded on the assignment are allocated to the “Analysis” section of
the memorandum. In assessing these assignments, consideration will be given to,
among other factors, (1) your accuracy in summarizing the relevant facts; (2) the
accuracy of your identification and statement of the “Issue” presented by the problem;
(3) the accuracy of your “Conclusion;” (4) the thoroughness and quality of your analysis
Week 3 Research Project (Set #1)
DeVry University Acct 429
offered in the “Analysis” section of your memorandum; and (5) the overall
professionalism of your memorandum (e.g., presentation, use of proper grammar,
proper spelling, and quality of communication). EACH OF THE TAX MEMORANDA IS
WORTH 30 POINTS, FOR A TOTAL OF 60 POINTS.
2. The remaining assignment requires you to perform some research on the Internet to
find relevant materials and to analyze these materials. As previously noted, in
performing this research, you may not take advantage of any resources other than those
specifically permitted by the assignment, including assignments previously completed by
other students or other similar materials. You will then complete an essay answering
the question or questions presented by this assignment. Your submission will be graded
on a number of factors, including (1) your ability to locate relevant research and
materials on the Internet; (2) your ability to analyze these resources; (3) your ability to
draw conclusions from these resources and to defend these conclusions with analysis of
the research and materials located; and (4) the overall professionalism and content of
your essay (e.g., presentation, use of proper grammar, proper spelling, and quality of
communication). THIS ESSAY IS WORTH 20 POINTS.
Please note that these assignments are worth a significant portion of your grade. As such, you
should take them seriously, and leave yourself enough time to complete them. Do not wait
until the last weekend to begin these assignments. If you do, it will be very difficult for you to
submit quality responses to each of the four questions or problems posed. Please also note
that preparing these answers conscientiously will help you in preparing for the final
examination, given that you may be required to perform similar analyses on the exam. Should
you have a question, please ask your instructor. Good luck!
Week 3 Research Project (Set #1)
DeVry University Acct 429
TAX RESEARCH MEMORANDUM ASSIGNMENT 1
One of your clients is an incorporated funeral home, Peaceful Pastures Funeral Home, Inc.
(“Peaceful”). Peaceful, an accrual basis taxpayer, provides a full line of funeral services and sells
goods related to those services. Over the last few years, however, the cost of these goods and
services have risen dramatically. As a result, more of Peaceful’s customers have had difficulties
paying their bills or have selected goods and services that cost less, sharply impacting Peaceful’s
bottom line.
As a result, Peaceful has attempted to design an approach that allows customers to prepay for
their funeral goods and services. Under this program, the customer pays in advance for the
goods and services that will be provided at the time of their death, often at a significant
discount. Under the terms of the contract, the payments are refundable at the contract
purchaser’s request any time until the goods and services are provided to them. Given that it is
an accrual basis taxpayer, Peaceful has included these payments and income for the year the
funeral service is provided.
This year, the IRS sent Peaceful an audit notice. It contends that the amount prepaid under
Peaceful’s program constitutes prepaid income that must be included in Peaceful’s income (and
therefore subject to tax) in the year in which it is received. Peaceful has come to you for
advice. Is the IRS correct?
COMPOSE A TAX FILE MEMORANDUM CONCERNING THIS ISSUE USING THESE FACTS AND THE
RESEARCH MATERIALS PROVIDED TO YOU IN THE NEXT FEW PAGES (30 POINTS).
Checkpoint Contents
Federal Library
Federal Source Materials
Federal Tax Decisions
American Federal Tax Reports
American Federal Tax Reports (Prior Years)
1990
AFTR 2d Vol. 65
65 AFTR 2d 90-407 (888 F.2d 208) – 65 AFTR 2d 90-301 (19 Cl Ct 1)
COMM. v. INDIANAPOLIS POWER & LIGHT CO., 65 AFTR 2d 90-394 (110 S.Ct.589), Code Sec(s) 451;
61, (S Ct), 01/09/1990
American Federal Tax Reports
COMM. v. INDIANAPOLIS POWER & LIGHT CO., Cite as 65 AFTR 2d 90-394
(110 S.Ct.589), 01/09/1990 , Code Sec(s) 61
COMMISSIONER of Internal Revenue, PETITIONER v. INDIANAPOLIS POWER & LIGHT COMPANY, RESPONDENT
Case Information:
HEADNOTE
1. TIME FOR REPORTING INCOME—Prepaid income—receipt for future services or sale of personal property.
Customer deposits required by public utility to insure customer creditworthiness and bill payment weren’t advance
payments for electricity and weren’t taxable income to utility on receipt. Utility didn’t have requisite “complete
dominion” over payments at time they were made, the crucial point for determining taxable income. 11th Circuit’s
holding in City Gas Co. of Fla. v. Comm., 50 AFTR 2d 82-5959 ( 689 F2d 943), not followed. Utility’s right to
keep deposits depended on events outside its control—customer’s purchase of electricity, decision to have deposit
applied to future bills, or default. Utility’s dominion over fund was far less complete than is ordinarily case in
advance-payment situation. Closest analogy is lease deposits.
Reference(s): PH Fed 2d ¶4515.191(90); ¶615.003(10). Code Sec. 61 ; Code Sec. 451 .
OPINION
On Writ of Certiorari to the United States Court of Appeals for the Seventh Circuit.
Syllabus
Respondent Indianapolis Power and Light Co. (IPL), a regulated Indiana utility and an accrual-basis taxpayer,
requires customers having suspect credit to make deposits with it to assure prompt payment of future electric bills.
Prior to termination of service, customers who satisfy a credit test can obtain a refund of their deposits or can
choose to have the amount applied against future bills. Although the deposits are at all times subject to the
company’s unfettered use and control, IPL does not treat them as income at the time of receipt but carries them on
its books as current liabilities. Upon audit of IPL’s returns for the tax years at issue, petitioner Commissioner of
Internal Revenue asserted deficiencies, claiming that the deposits are advance payments for electricity and
Code Sec(s): 61
Court Name: U.S. Supreme Court,
Docket No.: No. 88-1319,
Date
Decided: 01/09/1990
Prior History: Court of Appeals, 62 AFTR 2d 88-5708 ( 857 F.2d 1162), aff’g 88 TC 964
(No.52), affirmed.
Tax Year(s): Years 1974, 1975, 1976, 1977.
Disposition: Decision for Taxpayer.
Cites: 65 AFTR 2d 90-394, 493 US 203, 110 S Ct 589, 107 L Ed 2d 591, 90-1 USTC P 50007.
therefore are taxable to IPL in the year of receipt. The Tax Court ruled in favor of IPL on its petition for
redetermination, holding that the deposits’ principal purpose is to serve as security rather than a prepayment of
income. The Court of Appeals affirmed.
Held: The customer deposits are not advance payments for electricity and therefore do not constitute taxable
income to IPL upon receipt. Although IPL derives some economic benefit from the deposits, it does not have the
requisite “complete dominion” over them at the time they are made, the crucial point for determining taxable
income. IPL has an obligation to repay the deposits upon termination of service or satisfaction of the credit test.
Moreover, a customer submitting a deposit makes no commitment to purchase any electricity at all. Thus, while
deposits eventually may be used to pay for electricity by virtue of customer default or choice, IPL’s right to retain
them at the time they are made is contingent upon events outside its control. This construction is consistent with
the Tax Court’s longstanding treatment of sums deposited to secure a tenant’s performance of a lease agreement,
perhaps the closet analogy to the present situation.
857 F.2d 1162 [ 62 AFTR2d 88-5708], affirmed.
BLACKMUN, J., delivered the opinion for a unanimous Court.
Opinion
Justice BLACKMUN delivered the opinion of the Court.
Respondent Indianapolis Power & Light Company (IPL) requires certain customers to make deposits with it to assure
payment of future bills for electric service. Petitioner Commissioner of Internal Revenue contends that these deposits
are advance payments for electricity and therefore constitute taxable income to IPL upon receipt. IPL contends
otherwise.
I
IPL is a regulated Indiana corporation that generates and sells electricity in Indianapolis and its environs. It keeps its
books on the accrual and calendar year basis. [pg. 90-395] During the years 1974 through 1977, approximately 5%
of IPL’s residential and commercial customers were required to make deposits “to insure prompt payment,” as the
customers’ receipts stated, of future utility bills. These customers were selected because their credit was suspect.
Prior to March 10, 1976, the deposit requirement was imposed on a case-by-case basis. IPL relied on a credit test
but employed no fixed formula. The amount of the required deposit ordinarily was twice the customer’s estimated
monthly bill. IPL paid 3% interest on a deposit held for six months or more. A customer could obtain a refund of the
deposit prior to termination of service by requesting a review and demonstrating acceptable credit. The refund
usually was made in cash or by check, but the customer could choose to have the amount applied against future
bills.
In March 1976, IPL amended its rules governing the deposit program. See Title 170, Ind. Admin. Code 4-1-15 (1988).
Under the amended rules, the residential customers from whom deposits were required were selected on the basis of
a fixed formula. The interest rate was raised to 6% but was payable only on deposits held for 12 months or more. A
deposit was refunded when the customer made timely payments for either nine consecutive months, or for 10 out of
12 consecutive months so long as the two delinquent months were not themselves consecutive. A customer could
obtain a refund prior to that time by satisfying the credit test. As under the previous rules, the refund would be
made in cash or by check, or, at the customer’s option, applied against future bills. Any deposit unclaimed after
seven years was to escheat to the State. See Ind. Code §32-9-1-6(a) (1988) 1
IPL did not treat these deposits as income at the time of receipt. Rather, as required by state administrative
regulations, the deposits were carried on its books as current liabilities. Under its accounting system, IPL recognized
income when it mailed a monthly bill. If the deposit was used to offset a customer’s bill, the utility made the
necessary accounting adjustments. Customer deposits were not physically segregated in any way from the
company’s general funds. They were commingled with other receipts and at all times were subject to IPL’s
unfettered use and control. It is undisputed that IPL’s treatment of the deposits was consistent with accepted
accounting practice and applicable state regulations.
Upon audit of respondent’s returns for the calendar years 1974 through 1977, the Commissioner asserted
deficiencies. Although other items initially were in dispute, the parties were able to reach agreement on every issue
except that of the proper treatment of customer deposits for the years 1975, 1976, and 1977. The Commissioner
took the position that the deposits were advance payments for electricity and therefore were taxable to IPL in the
year of receipt. He contended that the increase or decrease in customer deposits outstanding at the end of each
year represented an increase or decrease in IPL’s income for the year. 2 IPL disagreed and filed a petition in the
United States Tax Court for redetermination of the asserted deficiencies.
In a reviewed decision, with one judge not participating, a unanimous Tax Court ruled in favor of IPL. 88 T.C. 964
(1987). The court followed the approach it had adopted in City Gas Co. of Florida v. Commissioner of Internal
Revenue, 74 T.C. 386 (1980), rev’d, 689 F.2d 943 [ 50 AFTR2d 82-5959] (CA 11 1982). It found it
necessary to “continue to examine all of the circumstances,” 88 T.C., at 976, and relied on several factors in
concluding that the deposits in question were properly excluded from gross income. It noted, among other things,
that only 5% of IPL’s customers were required to make deposits; that the customer rather than the utility controlled
the ultimate disposition of a deposit; and that IPL consistently treated the deposits as belonging to the customers,
both by listing them as current liabilities for accounting purposes and by paying interest. Id., at 976-978.
The United States Court of Appeals for the Seventh Circuit affirmed the Tax Court’s decision. 857 F.2d 1162 [
62 AFTR2d 88-5708] (1988). The court stated that “the proper approach to determining the appropriate tax
treatment of a customer deposit is to look at the primary purpose of the deposit based on all the facts and
circumstances….” Id., at 1167. [pg. 90-396] The court appeared to place primary reliance, however, on IPL’s
obligation to pay interest on the deposits. It asserted that ” as the interest rate paid on a deposit to secure income
begins to approximate the return that the recipient would be expected to make from ‘the use’ of the deposit amount,
the deposit begins to serve purposes that comport more squarely with a security deposit.” Id., at 1169. Noting that
IPL had paid interest on the customer deposits throughout the period in question, the court upheld, as not clearly
erroneous, the Tax Court’s determination that the principal purpose of these deposits was to serve as security
rather than as prepayment of income. Id., at 1170.
Because the Seventh Circuit was in specific disagreement with the Eleventh Circuit’s ruling in City Gas Co. of Florida,
supra, we granted certiorari to resolve the conflict. —U.S. — (1989).
II
We begin with the common ground. IPL acknowledges that these customer deposits are taxable as income upon
receipt if they constituteadvance payments for electricity to be supplied. 3 The Commissioner, on his part, concedes
that customer deposits that secure the performance of nonincome-producing covenants—such as a utility
customer’s obligation to ensure that meters will not be damaged—are not taxable income. And it is settled that
receipt of a loan is not income to the borrower. See Commissioner v. Tufts, 461 U.S. 300, 307 [ 51 AFTR2d
83-1132] (1983) (“Because of [the repayment] obligation, the loan proceeds do not qualify as income to the
taxpayer”); James v. United States, 366 U.S. 213, 219 [ 7 AFTR2d 1361] (1961) (accepted definition of
gross income “excludes loans”); Commissioner v. Wilcox, 327 U.S. 404, 408 [ 34 AFTR 811] (1946). IPL,
stressing its obligation to refund the deposits with interest, asserts that the payments are similar to loans. The
Commissioner, however, contends that a deposit which serves to secure the payment of future income is properly
analogized to an advance payment for goods or services. See Rev. Rul. 72-519, 1972-2 Cum. Bull. 32, 33 (“[W]
hen the purpose of the deposit is to guarantee the customer’s payment of amounts owed to the creditor, such a
deposit is treated as an advance payment, but when the purpose of the deposit is to secure a property interest of
the taxpayer the deposit is regarded as a true security deposit”).
In economic terms, to be sure, the distinction between a loan and an advance payment is one of degree rather than
of kind. A commercial loan, like an advance payment, confers an economic benefit on the recipient: a business
presumably does not borrow money unless it believes that the income it can earn from its use of the borrowed funds
will be greater than its interest obligation. See Illinois Power Co. v. Commissioner of Internal Revenue, 792 F.2d
683, 690 [ 58 AFTR2d 86-5122] (CA7 1986). Even though receipt of the money is subject to a duty to repay,
the borrower must regard itself as better off after the loan than it was before. The economic benefit of a loan,
however, consists entirely of the opportunity to earn income on the use of the money prior to the time the loan
must be repaid. And in that context our system is content to tax these earnings as they are realized. The recipient
of an advance payment, in contrast, gains both immediate use of the money (with the chance to realize earnings
thereon) and the opportunity to make a profit by providing goods or services at a cost lower than the amount of the
payment.
The question, therefore, cannot be resolved simply by noting that respondent derives some economic benefit from
receipt of these deposits. 4 Rather, the issue turns upon the nature of the rights and obligations that IPL assumed
when the deposits were made. In determining what sort of economic benefits qualify as income, this Court has
invoked various formulations. It has referred, for example, to “undeniable accessions to wealth, clearly realized, and
over which the taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co., [pg. 90-397] 348 U.S.
426, 431 [ 47 AFTR 162] (1955). It also has stated: “When a taxpayer acquires earnings, lawfully or unlawfully,
without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their
disposition, ‘he has received income….’ ” James v. United States, 366 U.S., at 219, quoting North American Oil
Consolidated v. Burnet, 286 U.S. 417, 424 [ 11 AFTR 16] (1932). IPL hardly enjoyed “complete dominion” over
the customer deposits entrusted to it. Rather, these deposits were acquired subject to an express “obligation to
repay,” either at the time service was terminated or at the time a customer established good credit. So long as the
customer fulfills his legal obligation to make timely payments, his deposit ultimately is to be refunded, and both the
timing and method of that refund are largely within the control of the customer.
The Commissioner stresses the fact that these deposits were not placed in escrow or segregated from IPL’s other
funds, and that IPL therefore enjoyed unrestricted use of the money. That circumstance, however, cannot be
dispositive. After all, the same might be said of a commercial loan; yet the Commissioner does not suggest that a
loan is taxable upon receipt simply because the borrower is free to use the funds in whatever fashion he chooses
until the time of repayment. In determining whether a taxpayer enjoys “complete dominion” over a given sum, the
crucial point is not whether his use of the funds is unconstrained during some interim period. The key is whether the
taxpayer has some guarantee that he will be allowed to keep the money. IPL’s receipt of these deposits was
accompanied by no such guarantee.
Nor is it especially significant that these deposits could be expected to generate income greater than the modest
interest IPL was required to pay. Again, the same could be said of a commercial loan, since, as has been noted, a
business is unlikely to borrow unless it believes that it can realize benefits that exceed the cost of servicing the
debt. A bank could hardly operate profitably if its earnings on deposits did not surpass its interest obligations; but
the deposits themselves are not treated as income. 5 Any income that the utility may earn through use of the
deposit money of course is taxable, but the prospect that income will be generated provides no ground for taxing
the principal.
The Commissioner’s advance payment analogy seems to us to rest upon a misconception of the value of an advance
payment to its recipient. An advance payment, like the deposits at issue here, concededly protects the seller
against the risk that it would be unable to collect money owed it after it has furnished goods or services. But an
advance payment does much more: it protects against the risk that the purchaser will back out of the deal before
the seller performs. From the moment an advance payment is made, the seller is assured that, so long as it fulfills its
contractual obligation, the money is its to keep. Here, in contrast, a customer submitting a deposit made no
commitment to purchase a specified quantity of electricity, or indeed to purchase any electricity at all. 6 IPL’s right
to keep the money depends upon the customer’s purchase of electricity, and upon his later decision to have the
deposit applied to future bills, not merely upon the utility’s adherence to its contractual duties. Under these
circumstances, IPL’s dominion over the fund is far less complete than is ordinarily the case in an advance-payment
situation.
The Commissioner emphasizes that these deposits frequently will be used to pay for electricity, either because the
customer defaults on his obligation or because the customer, having established credit, chooses to apply the deposit
to future bills rather than to accept a refund. When this occurs, the Commissioner argues, the transaction, from a
cash-flow standpoint, is equivalent to an advance payment. In his view this economic equivalence mandates
identical tax treatment.
Whether these payments constitute income when received, however, depends upon the parties’ rights and obligations at the time the
payments are made. The problem with petitioner’s argument perhaps can best be understood if we imagine a loan between parties
involved in an ongoing commercial relationship. At the time the loan falls due, the lender may decide to apply the money owed him to
the purchase of goods or services rather than to accept repayment in cash. But this decision does not mean that the loan, when made,
was an advance payment after all. The lender in effect has taken repayment of his money (as was his contractual right) and has chosen
to use the proceeds for the purchase of goods or services from the borrower. Although, for the sake of convenience, the parties may
combine the two steps, that decision does not blind us to the fact that in substance two transactions are involved. 8 It is this element of
choice that distinguishes an advance payment from a loan. Whether these customer deposits are the economic equivalents of advance
payments, and therefore taxable upon receipt, must be determined by examining the relationship between the parties at the time of the
deposit. The individual who makes an advance payment retains no right to insist upon the return of the funds; so long as the recipient
fulfills the terms of the bargain, the money is its to keep. The customer who submits a deposit to the utility, like the lender in the
previous hypothetical, retains the right to insist upon repayment in cash; he may choose to apply the money to the purchase of
electricity, but he assumes no obligation to do so, and the utility therefore acquires no unfettered “dominion” over the money at the
time of receipt.
When the Commissioner examines privately structured transactions, the true understanding of the parties, of course, may not be
apparent. It may be that a transfer of funds, though nominally a loan, may conceal an unstated agreement that the money is to be
applied to the purchase of goods or services. We need not, and do not, attempt to devise a test for addressing those situations where
the nature of the parties’ bargain is legitimately in dispute. This particular respondent, however, conducts its business in a heavily
regulated environment; its rights and obligations vis-a-vis its customers are largely determined by law and regulation rather than by
private negotiation. That the utility’s customers, when they qualify for refunds of deposits, frequently choose to apply those refunds to
future bills rather than taking repayment in cash does not mean that any customer has made an unspoken commitment to do so.
Our decision is also consistent with the Tax Court’s longstanding treatment of lease deposits—perhaps the closest analogy to the
present situation. The Tax Court traditionally has distinguished between a sum designated as a prepayment of rent—which is taxable
upon receipt—and a sum deposited to secure the tenant’s performance of a lease agreement. See, e.g., J. & E. Enterprises, Inc. v.
Commissioner, 26 TCM 944 [ ¶67,191 PH Memo TC](1967). 9 In fact, the customer deposits at issue here are less plausibly
regarded as income than lease deposits would be. The [pg. 90-399] typical lease deposit secures the tenant’s fulfillment of a contractual
obligation to pay a specified rent throughout the term of the lease. The utility customer, however, makes no commitment to purchase
any services at all at the time he tenders the deposit.
We recognize that IPL derives an economic benefit from these deposits. But a taxpayer does not realize taxable income from every
event that improves his economic condition. A customer who makes this deposit reflects no commitment to purchase services, and IPL’s
right to retain the money is contingent upon events outside its control. We hold that such dominion as IPL has over these customer
deposits is insufficient for the deposits to qualify as taxable income at the time they are made.
The judgment of the Court of Appeals is affirmed.
It is so ordered.
1
During the years 1974 through 1977, the total amount that escheated to the State was less than $9,325. Stipulation of Facts ¶25.
2
The parties’ stipulation sets forth the balance in IPL’s customer-deposit account on December 31 of each of the years 1954, 1974,
1975, 1976, and 1977. In his notice of deficiency, the Commissioner concluded that IPL was required to include in income for 1975 the
increase in the account between December 31, 1954, and December 31, 1975. For 1976 and 1977, IPL was allowed to reflect in income
the respective decreases in the account during those years.
3
This Court has held that an accrual-basis taxpayer is required to treat advance payments as income in the year of receipt. See
Schlude v. Commissioner, 372 U.S. 128 [ 11 AFTR2d 751] (1963); American Automobile Assn. v. United States, 367 U.S.
687 [ 7 AFTR2d 1618] (1961); Automobile Club of Michigan v. Commissioner, 353 U.S. 180 [ 50 AFTR 1967] (1957). These
cases concerned payments—nonrefundable fees for services—that indisputably constituted income; the issue waswhen that income was
taxable. Here, in contrast, the issue is whether these deposits, as such, are income at all.
4
See Illinois Power Co., 792 F.2d, at 690. See also Burke & Friel, Recent Developments in the Income Taxation of Individuals, Tax-Free
Security: Reflections on Indianapolis Power & Light, 12 Rev. of Taxation of Individuals 157, 174 (1988) (arguing that economic-benefit
approach is superior in theory, but acknowledging that “an economic-benefit test has not been adopted, and it is unlikely that such an
approach will be pursued by the Service or the courts”).
5
Cf. Rev. Rul. 71-189, 1971-1 Cum. Bull. 32 (inactive deposits are not income until bank asserts dominion over the accounts). See
also Fidelity-Philadelphia Trust Co. v. Commissioner, 23 T.C. 527 (1954).
6
A customer, for example, might terminate service the day after making the deposit. Also, IPL’s dominion over a deposit remains
incomplete even after the customer begins buying electricity. As has been noted, the deposit typically is set at twice the customer’s
estimated monthly bill. So long as the customer pays his bills in a timely fashion, the money he owes the utility (for electricity used but
not yet paid for) almost always will be less than the amount of the deposit. If this were not the case, the deposit would provide
inadequate protection. Thus, throughout the period the deposit is held, at least a portion is likely to be money that IPL has no real
assurance of ever retaining.
7
The Commissioner is unwilling, however, to pursue this line of reasoning to the limit of its logic. He concedes that these deposits would
not be taxable if they were placed in escrow, Tr. of Oral Arg. 4; but from a cash-flow standpoint it does not make much difference
whether the money is placed in escrow or commingled with the utility’s other funds. In either case, the utility receives the money and
allocates it to subsequent purchases of electricity if the customer defaults or chooses to apply his refund to a future bill.
8
The Commissioner contends that a customer’s decision to take his refund while making a separate payment for services, rather than
applying the deposit to his bill, would amount to nothing more than an economically meaningless “exchange of checks.” But in our view
the “exchange of checks,” while less convenient, more accurately reflects the economic substance of the transactions.
9
In J. & E. Enterprises the Tax Court stated: “If a sum is received by a lessor at the beginning of a lease, is subject to his unfettered
control, and is to be applied as rent for a subsequent period during the term of the lease, such sum is income in the year of receipt
even though in certain circumstances a refund thereof may be required…. If, on the other hand, a sum is deposited to secure the
lessee’s performance under a lease, and is to be returned at the expiration thereof, it is not taxable income even though the fund is
deposited with the lessor instead of in escrow and the lessor has temporary use of the money…. In this situation the acknowledged
liability of the lessor to account for the deposited sum on the lessee’s performance of the lease covenants prevents the sum from being
taxable in the year of receipt.” 26 TCM, at 945-946.
In Rev. Rul. 72-519, 1972-2 Cum. Bull. 32, the Commissioner relied in part on J. & E. Enterprises as authority for the proposition
that deposits intended to secure income-producing covenants are advance payments taxable as income upon receipt, while deposits
intended to secure nonincome-producing covenants are not. Id., at 33. In our view, neither J. & E. Enterprises nor the other cases cited
in the Revenue Ruling support that distinction. See Hirsch Improvement Co. v. Commissioner of Internal Revenue, 143 F.2d 912 [
32 AFTR 1104] (CA2), cert. denied, 323 U.S. 750 (1944); Mantell v. Commissioner, 17 T.C. 1143 (1952); Gilken Corp. v.
Commissioner, 10 T.C. 445 (1948), aff’d, 176 F.2d 141 [ 38 AFTR 265] (CA6 1949). These cases all distinguish between
advance payments and security deposits, not between deposits that do and do not secure income-producing covenants.
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Federal Library
Federal Source Materials
Federal Tax Decisions
Tax Court Memorandum Decisions
Tax Court & Board of Tax Appeals Memorandum Decisions (Prior Years)
2003
TC Memo 2003-348 – TC Memo 2003-309
Perry Funeral Home, Inc., TC Memo 2003-340, Code Sec(s). 451; 6662; 7491, 12/16/2003
Tax Court & Board of Tax Appeals Memorandum Decisions
Perry Funeral Home, Inc. v. Commissioner, TC Memo 2003-340 , Code Sec
(s) 451.
PERRY FUNERAL HOME, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Case Information:
HEADNOTE
1. Time for reporting income—accrual method—refundable deposit vs. advance payments—pre-need
funeral contracts. Accrual-method funeral home corp. properly reported monies received for Massachusettsregulated pre-need funeral service contracts in year services were actually rendered, rather than in payment year
as IRS contended: following Supreme Court precedent, payments were refundable deposits, not advance payments,
where contracts contained open-ended cancellation and refund rights that left taxpayer without complete dominion
and control over funds. Notably, under contracts’ plain language and pursuant to Massachusetts regs], customers
controlled whether or when refund would be made; and fact that cancellation/refund rights were rarely exercised
was irrelevant.
Reference(s): ¶ 4515.191(22) Code Sec. 451
2. Accuracy-related penalties—burden of proof and production—substantial authority—reliance on return
preparer. Accuracy-related penalties for negligence and/or substantial understatement were upheld to extent
applicable after Rule 155 computations against funeral home corp. with respect to conceded items: IRS met its
burden of production as to subject items through presumptively correct deficiency notice and taxpayer’s
concessions; taxpayer showed no substantial authority for or adequate disclosure of those items; and alleged
reliance on return preparer wasn’t excuse absent proof that preparer was given all necessary information as to
subject items.
Reference(s): ¶ 66,625.01(20) ; ¶ 74,915.03(3) Code Sec. 6662 ; Code Sec. 7491
Syllabus
Official Tax Court Syllabus
P is a funeral home organized and operating in Massachusetts. During the years in issue, P entered into
preneed funeral contracts and received payments in advance of death for goods and services to be
provided later at the contract beneficiary’s death. These payments were refundable at the contract
purchaser’s request, pursuant to State law, at any time until the goods and services were furnished. P,
an accrual basis taxpayer, included these payments in income not in the year of receipt but in the year
in which the goods and services were provided.
Code Sec(s): 451
Docket: Dkt. No. 14722-02.
Date Issued: 12/16/2003.
Judge: Opinion by Wherry, J.
Tax Year(s): Years 1996, 1997.
Disposition: Decision for Taxpayer in part and for Commissioner in part.
Held: Payments received by P under its preneed funeral contracts are includable in gross income only
upon the provision of the subject goods and services.
Held, further, P is liable for the sec. 6662, I.R.C., accuracy-related penalty with respect to items
conceded by P, apart from the preneed accounting issue.
Counsel
Edward DeFranceschi, David Klemm, and Jason Bell, for petitioner.
Louise R. Forbes, for respondent.
WHERRY, Judge
MEMORANDUM FINDINGS OF FACT AND OPINION
Respondent determined the following deficiencies and penalty with respect to petitioner’s Federal income taxes for
the calendar years 1996 and 1997:
Penalty
Year Deficiency I.R.C. Sec. 6662
—- ———- —————-
1996 $1,044,037 $106,877.80
1997 1,817 —
After concessions by the parties, the principal issues for decision are: [pg. 1968]
(1) Whether payments received by petitioner under preneed funeral contracts are includable in gross income during
the year of receipt or during the year in which the goods and services are provided by petitioner; and
(2) whether petitioner is liable for the section 6662 accuracy-related penalty. 1
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of the parties, with accompanying
exhibits, are incorporated herein by this reference.
Petitioner is a funeral home located at all relevant times in New Bedford, Massachusetts. Petitioner began operations
in 1963 as a partnership and was incorporated under the laws of the Commonwealth of Massachusetts on September
19, 1967. Brothers Thomas Perry and William Perry each own a 50-percent interest in petitioner and are funeral
directors licensed by the Commonwealth of Massachusetts.
Petitioner’s Operations
Prior to and during the years in issue, petitioner entered into preneed funeral contracts. Under these arrangements,
the contract purchaser selected, on a prospective basis, the goods and services to be provided by petitioner at the
contract beneficiary’s death. Petitioner would designate the selected items and applicable charges on a written
form.
If the resultant balance was then paid in advance of death, either in a lump sum or in installments, petitioner agreed
to honor the contract at death as written, without additional cost to the purchaser or family. If the resultant
balance was to be paid through the proceeds of an insurance policy or was left unfunded, the amount due would be
recalculated in accordance with the prices in effect at the time of death.
The written form used by petitioner for these purposes was not specific to prearranged funerals and contained no
express provisions regarding the use or refundability of amounts received thereunder. A handwritten notation that
the contract was irrevocable was added to certain of the forms, allegedly for reasons related to Medicaid eligibility.
Regardless of such language, however, it was petitioner’s practice to indicate to purchasers that they had the right
to cancel at any time and would receive their money back. 2
The experience of petitioner has been that only a very small percentage of preneed contracts are in fact canceled.
The record indicates that during the period from approximately 1997 through the time of trial in 2003, six contracts
were canceled. 3 The amounts paid thereon were refunded, and on certain occasions the refunds also included an
interest component based on “kind of a guess” about prevailing rates.
During the years in issue, petitioner maintained a business checking account and the following investments: A
Putnam Investments mutual fund account, a Merrill Lynch ready asset account, Fleet Financial shares,
Massachusetts Savings Investments certificates of deposit, a BayBank money market account, a BayBrokerage
account (for 1996 only), and a BayBank escrow account. Moneys received pursuant to preneed contracts were
placed by petitioner in one of the investment vehicles. Upon petitioner’s provision of goods and services at the
death of a preneed contract beneficiary, an amount equal to the purchase price of the contract was transferred
from the investment accounts to petitioner’s checking account.
The BayBank escrow account is a compilation of accounts, opened before 1996, each in the name of an individual
contract beneficiary. Petitioner’s accountant advised establishment of the escrow account in the early 1990s. This
account was used for the deposit of preneed receipts for a period prior to the years in issue, until the resultant
administrative burden caused petitioner to discontinue the practice. The balance of the BayBank escrow account as
of January [pg. 1969] 1, 1996, was $106,579.16, and those funds are not at issue in this proceeding. The
investments other than the Baybank escrow account are held solely in petitioner’s name and list petitioner’s tax
identification number.
Petitioner’s Accounting and Tax Reporting
Petitioner is an accrual basis taxpayer. For accounting purposes, petitioner records payments received pursuant to
preneed contracts as liabilities under the designation prearranged funerals. Petitioner does not recognize as income
payments recorded on its books and records as prearranged funerals until the tax year in which the goods and
services are provided. Petitioner does recognize interest and dividend income earned on the investments, exclusive
of the BayBank escrow account, into which the preneed funds are deposited.
Petitioner filed Forms 1120, U.S. Corporation Income Tax Return, for 1996, 1997, and 1998 consistent with the
foregoing approach. Attached to each return is a Schedule L, Balance Sheets per Books. These Schedules L reflect
as “Other investments” the following balances in petitioner’s investment vehicles, including the BayBank escrow
account:
Year As of Jan. 1 As of Dec. 31
—- ———— ————-
1996 $2,270,655 $2,431,946
1997 2,431,946 2,515,217
1998 2,515,217 2,503,934
Also on the Schedules L, petitioner included in “Other current liabilities” the following amounts for prearranged
funerals:
Year As of Jan. 1 As of Dec. 31
—- ———— ————-
1996 $1,587,416 $1,612,272
1997 1,612,272 1,614,929
1998 1,614,929 1,543,284
Respondent on June 26, 2002, issued to petitioner the statutory notice of deficiency underlying the present
litigation. Therein, respondent determined, inter alia, that moneys received under preneed contracts are to be
characterized as income to petitioner in the year of receipt.
OPINION
I. Preliminary Matters
A. Burden of Proof
In general, the Commissioner’s determinations are presumed correct, and the taxpayer bears the burden of proving
otherwise. Rule 142(a). Section 7491, effective for court proceedings that arise in connection with examinations
commencing after July 22, 1998, may operate, however, in specified circumstances to place the burden on the
Commissioner. Internal Revenue Restructuring & Reform Act of 1998, Pub. L. 105-206, sec. 3001(c), 112 Stat.
727. With respect to factual issues and subject to enumerated limitations, section 7491(a) may shift the burden
of proof to the Commissioner in instances where the taxpayer has introduced credible evidence. Concerning penalties
and additions to tax, section 7491(c) places the burden of production on the Commissioner.
The record in this case is not explicit as to when the underlying examination began. 4 As regards the substantive
accounting issues, however, the Court finds it unnecessary to decide whether the burden should be shifted under
section 7491(a). Few facts concerning how petitioner conducted the preneed transactions are in dispute. Given
this circumstance, the record is not evenly weighted and is more than sufficient to render a decision on the merits
based upon a preponderance of the evidence. With respect to the penalty, because respondent on brief assumes
that section 7491(c) is applicable, the Court will do likewise.
B. Evidentiary Motion
After the trial in this case, petitioner filed a motion for the Court to take judicial notice of the consent judgment
rendered in Commonwealth v. Deschene-Costa, C.A. [pg. 1970] No. C03-0647 (Mass. Super. Ct. June 4, 2003). The
motion is made pursuant to rule 201 of the Federal Rules of Evidence, which provides in relevant part as follows:
Rule 201. Judicial Notice of Adjudicative Facts
(a) Scope of rule.—This rule governs only judicial notice of adjudicative facts.
(b) Kinds of facts.—A judicially noticed fact must be one not subject to reasonable dispute in that it is
either (1) generally known within the territorial jurisdiction of the trial court or (2) capable of accurate
and ready determination by resort to sources whose accuracy cannot reasonably be questioned.
This Court has previously noted that “under rule 201, records of a particular court in one proceeding commonly are
the subject of judicial notice by the same and other courts in other proceedings”, and “Also generally subject to
judicial notice under rule 201 is the fact that a decision or judgment was entered in a case, that an opinion was
filed, as well as the language of a particular opinion.” Estate of Reis v. Commissioner, 87 T.C. 1016, 1027 (1986).
In the judgment that is the subject of petitioner’s motion, the defendant funeral home operator, when confronted by
the Commonwealth of Massachusetts, consented to a permanent injunction and to payment of restitution for misuse
of funeral trust funds. Commonwealth v. Deschene-Costa, supra. Respondent agrees that the Court may take
judicial notice of the judgment under the above-quoted standards of rule 201 but questions the relevance of the
material. Accordingly, the Court will take judicial notice of the existence and content of the judgment pursuant to
rule 201 but will give it only such consideration as is warranted by its pertinence to the Court’s analysis of
petitioner’s case.
II. General Rules
A. Federal Taxation Principles
The Internal Revenue Code imposes a Federal tax on the taxable income of every corporation. Sec. 11(a).
Section 61(a) specifies that gross income for purposes of calculating such taxable income means “all income from
whatever source derived”. Encompassed within this broad pronouncement are all “undeniable accessions to wealth,
clearly realized, and over which the taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co.,
348 U.S. 426, 431 [47 AFTR 162] (1955). Stated otherwise, gross income includes earnings unaccompanied by an
obligation to repay and without restriction as to their disposition. James v. United States, 366 U.S. 213, 219 [7
AFTR 2d 1361] (1961).
Section 451(a) provides the following general rule regarding the year in which items of gross income should be
included in taxable income:
The amount of any item of gross income shall be included in the gross income for the taxable year in
which received by the taxpayer, unless, under the method of accounting used in computing taxable
income, such amount is to be properly accounted for as of a different period.
Consistent with the principle of section 451, section 446(a) and (b) directs that taxpayers are to
compute taxable income using the method of accounting regularly employed for keeping their books, with the
exception that “if the method used does not clearly reflect income, the computation of taxable income shall be made
under such method as, in the opinion of the Secretary, does clearly reflect income.” In general, the accrual method
is designated a permissible method of accounting for purposes of section 446. Sec. 446(c)(2).
Under the accrual method, income is to be included for the taxable year when all events have occurred that fix the
right to receive the income and the amount of the income can be determined with reasonable accuracy. Secs.
1.446-1(c)(1)(ii), 1.451- 1(a), Income Tax Regs. Typically, all events that fix the right to receive income have
occurred upon the earliest of the following to take place: The income is (1) actually or constructively received; (2)
due; or (3) earned by performance. Schlude v. Commissioner, 372 U.S. 128, 133 [11 AFTR 2d 751] (1963);
Johnson v. Commissioner, 108 T.C. 448, 459 (1997), affd. in part, revd. in part and remanded on another ground
184 F.3d 786 [84 AFTR 2d 99-5306] (8th Cir. 1999). [pg. 1971]
As caselaw applying the above standards has evolved, it has become well established that amounts constituting
advance payments for goods or services are includable in gross income in the year received. Schlude v.
Commissioner, supra; AAA v. United States, 367 U.S. 687 [7 AFTR 2d 1618] (1961); Auto. Club of Mich. v.
Commissioner, 353 U.S. 180 [50 AFTR 1967] (1957); RCA Corp. v. United States, 664 F.2d 881 [48 AFTR 2d
81-6164] (2d Cir. 1981); see also Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203, 207 & n.3 [65
AFTR 2d 90-394] (1990).
In contrast, amounts properly characterized as loans, deposits, or trust funds are not includable upon receipt.
Commissioner v. Indianapolis Power & Light Co., supra at 207-208; Johnson v. Commissioner, supra at 467-475; Oak
Indus., Inc. v. Commissioner, 96 T.C. 559, 563-564 (1991); Angelus Funeral Home v. Commissioner, 47 T.C.
391, 397 (1967), affd. 407 F.2d 210 [23 AFTR 2d 69-673] (9th Cir. 1969). The rationale underlying this
distinction is that money received in the capacity solely of a borrower, depository, agent, or fiduciary, because it is
accompanied by an obligation to repay or restriction as to disposition, is not income at all. See Commissioner v.
Indianapolis Power & Light Co., supra at 208 n.3; Johnson v. Commissioner, supra at 474-475. Hence, no question of
the timing of income accrual is presented. See Commissioner v. Indianapolis Power & Light Co., supra at 208 n.3;
Johnson v. Commissioner, supra at 474-475.
B. State Funeral Services Regulation
Preneed contracts and arrangements in the Commonwealth of Massachusetts are governed by the regulations of the
Board of Registration in Embalming and Funeral Directing. Mass. Regs. Code tit. 239, secs. 4.01-4.10 (2003); see
also Mass. Gen. Laws Ann. ch. 112, sec. 85 (West 2003) (authorizing the board to adopt, promulgate, and
enforce regulations). For purposes of these regulations, a “pre-need funeral contract” is defined as “any pre- need
funeral services contract or pre-need funeral arrangements contract, entered into in advance of death”. Mass. Regs.
Code tit. 239, sec. 4.01 (2003). A “pre-need funeral services contract”, in turn, is:
any written agreement whereby a licensed funeral establishment agrees, prior to the death of a named
person, to provide specifically-identified funeral goods and/or services to that named person upon
his/her death, and which is signed by both the buyer and a duly authorized representative of the
licensed funeral establishment. [Id.]
Similarly, “pre-need funeral arrangements contract” means:
any written arrangement between a licensed funeral establishment and another person which establishes
a source of funds to be used solely for the purpose of paying for funeral goods and/or services for a
named person, but which does not identify the specific funeral goods and/or services to be furnished to
that person. [Id.]
The regulations set forth the required contents of “pre-need funeral contracts”. Mass. Regs. Code tit. 239, sec.
4.03 (2003). As pertains to funding, contracts are to contain the following:
A written acknowledgement, signed by the buyer, which indicates that:
1. The buyer has established a funeral trust fund pursuant to 239 CMR 4.00 and has received all
disclosures required by 239 CMR 4.06(3); or
2. The buyer has elected to purchase a pre-need insurance policy or annuity and has received all
disclosures required by 239 CMR 4.07(2); or
3. The buyer has tendered payment in full for all funeral goods and services specified in the contract and
has received satisfactory written evidence that those goods or services will be furnished at time of
death; or
4. The buyer has declined to select a funding method and has paid no money to the funeral
establishment; [Mass. Regs. Code tit. 239, sec. 4.03(1)(d) (2003).]
A “funeral trust” within the meaning of the foregoing provision is “a written [pg. 1972] agreement of trust whereby
funds are transferred to a named trustee with the intention that the trustee will manage and administer those funds
for the benefit of a named beneficiary and use those funds to pay for funeral goods and/or services to be furnished
to that named beneficiary.” Mass. Regs. Code tit. 239, sec. 4.01 (2003).
Cancellation rights likewise are specified in the regulations, as follows:
Any buyer of a pre-need funeral contract may cancel that contract and receive a full refund of all
monies paid, without penalty, at any time within ten days after signing said contract. After the
expiration of this ten-day “cooling off period” a pre-need funeral contract may be canceled in
accordance with 239 CMR 4.06(8). [Mass. Regs. Code tit. 239, sec. 4.05(1) (2003).]
The referenced Mass. Regs. Code tit. 239, sec. 4.06(8) (2003) reads, in pertinent part:
The buyer who signed a pre-need funeral contract, or his/her legal representative, may cancel a preneed funeral contract with a licensed funeral establishment at any time by sending written notice of
such cancellation, via certified mail, return receipt requested, to said funeral establishment. If a funeral
trust has been established to fund said pre-need funeral contract, and the licensed funeral
establishment is not the trustee, the buyer shall forward a copy of said notice of cancellation to the
named trustee of said funeral trust.
III. Contentions of the Parties
We turn now to the parties’ contentions regarding application of the foregoing rules to petitioner’s situation.
Petitioner contends that the payments received pursuant to preneed contracts are not includable in gross income
until the underlying funeral goods and services are provided. In support of this assertion, petitioner references three
alternative theories for exclusion. Petitioner’s primary argument is that the payments constitute nontaxable deposits
under the reasoning of Commissioner v. Indianapolis Power & Light Co., supra. Additionally, petitioner maintains that
the amounts at issue should be characterized as trust funds akin to those excluded from income in cases such as
Angelus Funeral Home v. Commissioner, supra. Petitioner’s third basis for its treatment of the payments is that even
if the amounts are found to be advance payments of income, rather than deposits or trust funds, their deferral is
appropriate under the exception established in Artnell Co. v. Commissioner, 400 F.2d 981 [22 AFTR 2d 5590] (7th
Cir. 1968), revg. and remanding 48 T.C. 411 (1967), to the general rule requiring immediate inclusion of
advances.
With respect to the section 6662 penalty, petitioner argues that the lines of cases cited above provide
substantial authority and reasonable cause for taking the position that the funds received for preneed contracts
were not income or property of petitioner.
In contrast, respondent contends that petitioner obtained dominion and control over the preneed funds at the time
of receipt such that the amounts are properly included in income as advance payments under the all events test.
Respondent further argues that each of the exceptions relied upon by petitioner is inapplicable on these facts.
Specifically, it is respondent’s position that advance payments for services to be rendered by the taxpayer are not
the equivalent of a refundable security deposit or loan and, hence, are not controlled by the standards set forth in
Commissioner v. Indianapolis Power & Light Co., supra. Second, respondent emphasizes that petitioner’s control over
the funds and the absence of any contractual or legal restrictions preclude treating the moneys as in trust. 5 Finally,
respondent alleges that petitioner cannot qualify for the limited Artnell Co. v. Commissioner, supra, exception to the
all events test where there exists no certainty as to when or whether petitioner will perform under the contracts.
In connection with the section 6662 penalty, respondent disputes petitioner’s assertions of substantial authority
and reasonable cause. Respondent points particularly [pg. 1973] to the reporting by petitioner of interest on the
preneed payments, the choice to invest the funds in petitioner’s name rather than in regulated trust accounts, and
the advice petitioner received from its accountant pertaining to the BayBank escrow account.
IV. Preneed Accounting
We first consider whether the preneed payments at issue should be treated as deposits governed by Commissioner
v. Indianapolis Power & Light Co., 493 U.S. 203 [65 AFTR 2d 90-394] (1990). The Supreme Court in Commissioner
v. Indianapolis Power & Light Co., supra at 210, established what is referred to as the “complete dominion” test for
identifying those payments over which the taxpayer has such control as to render them income:
In determining whether a taxpayer enjoys “complete dominion” over a given sum, the crucial point is not
whether his use of the funds is unconstrained during some interim period. The key is whether the
taxpayer has some guarantee that he will be allowed to keep the money. ***
Further, the answer to this inquiry “depends upon the parties’ rights and obligations at the time the payments are
made .” Id. at 211.
With respect to distinguishing between taxable advance payments and nontaxable deposits, the Supreme Court
further explained:
An advance payment, like the deposits at issue here, concededly protects the seller against the risk
that it would be unable to collect money owed it after it has furnished goods or services. But an
advance payment does much more: it protects against the risk that the purchaser will back out of the
deal before the seller performs. From the moment an advance payment is made, the seller is assured
that, so long as it fulfills its contractual obligation, the money is its to keep. Here, in contrast, a
customer submitting a deposit made no commitment to purchase a specified quantity of electricity, or
indeed to purchase any electricity at all. IPL’s right to keep the money depends upon the customer’s
purchase of electricity, and upon his later decision to have the deposit applied to future bills, not merely
upon the utility’s adherence to its contractual duties. ***
***
It is this element of choice that distinguishes an advance payment * * * The individual who makes an
advance payment retains no right to insist upon the return of the funds; so long as the recipient fulfills
the terms of the bargain, the money is its to keep. The customer who submits a deposit to the utility
*** retains the right to insist upon repayment in cash; he may choose to apply the money to the
purchase of electricity, but he assumes no obligation to do so, and the utility therefore acquires no
unfettered “dominion” over the money at the time of receipt. [Id. at 210- 212; fn. ref. omitted.]
This Court, in applying the reasoning of Commissioner v. Indianapolis Power & Light Co., supra, has similarly
emphasized the importance of which party controls the conditions under which repayment or refund of the disputed
amounts will be made. See, e.g., Herbel v. Commissioner, 106 T.C. 392, 413-414 (1996), affd. 129 F.3d 788
[80 AFTR 2d 97-8172] (5th Cir. 1997); Highland Farms, Inc. v. Commissioner, 106 T.C. 237, 251-252 (1996);
Kansas City S. Indus., Inc. v. Commissioner, 98 T.C. 242, 262 (1992); Michaelis Nursery, Inc. v. Commissioner,
T.C. Memo. 1995-143 [1995 RIA TC Memo ¶95,143]. We have summarized that “if the payor controls the
conditions under which the money will be repaid or refunded, generally, the payment is not income to the recipient.”
Herbel v. Commissioner, supra at 413. “On the other hand, if the recipient of the payment controls the conditions
under which the payment will be repaid or refunded, we have held that the recipient has some guaranty that it will
be allowed to keep the money, and hence, the recipient enjoys complete dominion over the payment.” Id. at 414.
[pg. 1974]
Thus, while refundability per se is insufficient for identifying nontaxable deposits, Johnson v. Commissioner, 108
T.C. 448, 470-471 (1997), refundability within the buyer’s control and outside that of the seller is a significant
indicator under the current jurisprudence. Additionally, to the extent that any further factual refinement is
warranted to distinguish “the Indianapolis Power & Light line of cases” from earlier opinions discounting the
importance of the refundability criterion, the law classifying amounts as nontaxable deposits is clear at least insofar
as “the taxpayer’s right to retain them was contingent upon the customer’s future decisions to purchase services
and have the deposits applied to the bill.” Johnson v. Commissioner, supra at 471.
As to other potential indicia, both the Supreme Court in Commissioner v. Indianapolis Power & Light Co., supra, and
this Court have held that factors such as control over deposits (i.e., absence of a trust fund), unrestricted use,
nonpayment of interest, and later application of the moneys to services are probative but not dispositive in
evaluating the existence of complete dominion. Id. at 209-211; Highland Farms, Inc. v. Commissioner, supra at 251;
Kansas City S. Indus., Inc. v. Commissioner, supra at 261-262; Oak Indus., Inc. v. Commissioner, 96 T.C. 559,
569-574 (1991); Michaelis Nursery, Inc. v. Commissioner, supra.
With respect to the facts before us, here petitioner’s customers, and not petitioner, controlled whether and when
any refund of the preneed funds would be made. The regulatory scheme governing preneed funeral contracts
expressly affords buyers the right to cancel such contracts at any time. Mass. Regs. Code tit. 239, secs. 4.05, 4.06
(8) (2003). Further, while Mass. Regs. Code tit. 239, sec. 4.06(8) (2003), contains a more detailed description of
the applicable cancellation procedures in the event that a funeral trust has been established, the express text
covers preneed funeral contracts and does not limit this cancellation right to those instances involving a funeral
trust. Accordingly, whether or not petitioner placed the preneed funds in trust is not crucial to our analysis of the
refundability criterion.
In addition, in view of respondent’s comments on brief suggesting that petitioner’s historical percentage of
cancellations was so low that the right should be disregarded, we emphasize that it is the bona fide existence of
such a right, not the exercise or frequency of exercise, which controls. Because the cancellation right is State
granted, 6 we do not face a situation where the outcome might implicate questions concerning the nature and
legitimacy of the bargain between particular parties. Also, we would be hard pressed to say that the right here was
illusory when cancellations did occur, and corresponding refunds were given, in the course of petitioner’s business.
The consequence of this fixed right is that, to the extent Commissioner v. Indianapolis Power & Light Co., 493 U.S.
at 210, identifies an advance payment as one which protects against the risk that the buyer will back out before the
seller has a chance to perform, the preneed contracts and payments fail to serve that function. Moreover, the
practical reality of the funeral services business renders this situation analogous to the factual scenario noted in
Johnson v. Commissioner, supra at 471, as a hallmark of those refundable receipts clearly within the reasoning of
Commissioner v. Indianapolis Power & Light Co., supra. On account of the open-ended, “at any time”, nature of the
cancellation right, petitioner’s opportunity to perform the designated services and in fact earn the preneed funds
(thereby eliminating the cancellation right) was contingent upon the later choice of the decedent’s survivors or
representative actually to call upon petitioner to act under the contract.
The mere execution of a preneed contract did not place petitioner in a position to fulfill the terms of the bargain. As
a [pg. 1975] practical matter, because the ultimate decision to purchase frequently rested in the hands of third
parties, there existed in these situations what more closely resembles a condition precedent to petitioner’s right to
perform than a condition subsequent that would eliminate a current right to so act. See Charles Schwab Corp. &
Subs. v. Commissioner, 107 T.C. 282, 293 (1996) (distinguishing conditions precedent and subsequent in the
context of income accrual), affd. 161 F.3d 1231 [82 AFTR 2d 98-7364] (9th Cir. 1998).
The Court is satisfied that the totality of the unique circumstances of petitioner’s business brings it within the
rationale of Commissioner v. Indianapolis Power & Light Co., supra, and its progeny. We hold that the amounts
received by petitioner under these preneed funeral contracts are includable in income only upon the provision of the
subject goods and services. Furthermore, given this conclusion based upon Commissioner v. Indianapolis Power &
Light Co., supra, we need not reach petitioner’s alternative contentions regarding excludable trust funds or deferred
recognition of advance payments.
V. Section 6662 Penalty
Subsection (a) of section 6662 imposes an accuracy-related penalty in the amount of 20 percent of any
underpayment that is attributable to causes specified in subsection (b). Subsection (b) of section 6662 then
provides that among the causes justifying imposition of the penalty are: (1) Negligence or disregard of rules or
regulations and (2) any substantial understatement of income tax.
“Negligence” is defined in section 6662(c) as “any failure to make a reasonable attempt to comply with the
provisions of this title”, and “disregard” as “any careless, reckless, or intentional disregard.” Caselaw similarly states
that “`Negligence is a lack of due care or the failure to do what a reasonable and ordinarily prudent person would do
under the circumstances.’” Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting Marcello v. Commissioner,
380 F.2d 499, 506 [19 AFTR 2d 1700] (5th Cir. 1967), affg. on this issue 43 T.C. 168 (1964) and T.C.
Memo. 1964-299 [¶64,299 PH Memo TC]), affd. 904 F.2d 1011 [66 AFTR 2d 90-5322] (5th Cir. 1990), affd.
501 U.S. 868 [68 AFTR 2d 91-5025] (1991). Pursuant to regulations, “`Negligence’ also includes any failure by the
taxpayer to keep adequate books and records or to substantiate items properly.” Sec. 1.6662-3(b)(1), Income
Tax Regs.
A “substantial understatement” is declared by section 6662(d)(1) to exist where the amount of the
understatement exceeds the greater of 10 percent of the tax required to be shown on the return for the taxable
year or $5,000 ($10,000 in the case of a corporation). For purposes of this computation, the amount of the
understatement is reduced to the extent attributable to an item: (1) For which there existed substantial authority
for the taxpayer’s treatment thereof, or (2) with respect to which relevant facts were adequately disclosed on the
taxpayer’s return or an attached statement and there existed a reasonable basis for the taxpayer’s treatment of the
item. See sec. 6662(d)(2)(B).
An exception to the section 6662(a) penalty is set forth in section 6664(c)(1) and reads: “No penalty shall
be imposed under this part with respect to any portion of an underpayment if it is shown that there was a
reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”
Regulations interpreting section 6664(c) state:
The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a
case-by-case basis, taking into account all pertinent facts and circumstances. *** Generally, the most
important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper tax liability. *** [
Sec. 1.6664-4(b)(1), Income Tax. Regs.]
Reliance upon the advice of an expert tax preparer may, but does not necessarily, demonstrate reasonable cause
and good faith in the context of the section 6662(a) penalty. Id.; see also United States v. Boyle, 469 U.S.
241, 251 [55 AFTR 2d [pg. 1976] 85-1535] (1985); Freytag v. Commissioner, supra at 888. Such reliance is not an
absolute defense, but it is a factor to be considered. Freytag v. Commissioner, supra at 888.
In order for this factor to be given dispositive weight, the taxpayer claiming reliance on a professional must show, at
minimum, that (1) the preparer was supplied with correct information and (2) the incorrect return was a result of the
preparer’s error. See, e.g., Westbrook v. Commissioner, 68 F.3d 868, 881 [76 AFTR 2d 95- 7397] (5th Cir. 1995),
affg. T.C. Memo. 1993-634 [1993 RIA TC Memo ¶93,634]; Cramer v. Commissioner, 101 T.C. 225, 251
(1993), affd. 64 F.3d 1406 [76 AFTR 2d 95-6482] (9th Cir. 1995); Ma-Tran Corp. v. Commissioner, 70 T.C.
158, 173 (1978); Pessin v. Commissioner, 59 T.C. 473, 489 (1972).
As previously indicated, section 7491(c) places the burden of production on the Commissioner. The Commissioner
satisfies this burden by “com[ing] forward with sufficient evidence indicating that it is appropriate to impose the
relevant penalty” but “need not introduce evidence regarding reasonable cause, substantial authority, or similar
provisions.” Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Rather, “it is the taxpayer’s responsibility to raise
those issues.” Id.
The notice of deficiency issued to petitioner determined applicability of the section 6662(a) penalty for 1996 on
account of both negligence and/or substantial understatement. 7 To the extent that we have ruled in petitioner’s
favor on the accounting issue presented for decision, there can be no underpayment or corresponding penalty
attributable thereto.
However, petitioner also conceded several other adjustments for 1996. 8 The record is entirely devoid of any
information regarding the circumstances surrounding petitioner’s position on these items, which include amounts
claimed for beginning inventory, cost of goods sold, legal and professional fees, and depreciation. To the extent that
these concessions result in an underpayment, we conclude that respondent has satisfied his burden under
section 7491(c) of production of sufficient evidence. At minimum, nothing suggests that these errors were other
than negligent. We also note that the threshold determination of any remaining substantial understatement is
primarily a computational matter, which we leave to the parties.
Accordingly, the burden rests on petitioner to show mitigating circumstances such as substantial authority, a
reasonable basis, or reasonable cause. Petitioner on brief claims to have had substantial authority, a reasonable
basis, reasonable cause, and good faith with respect to its reporting of the preneed contract payments. In contrast,
petitioner directs no comments to the various conceded adjustments, nor did petitioner introduce any evidence
pertaining to these items. Furthermore, although petitioner generally points out that its returns were prepared by a
professional tax adviser, again there has been no showing whatsoever regarding what information petitioner supplied
on the conceded items. We therefore lack grounds on which to conclude that the incorrect return resulted from the
preparer’s errors. Respondent’s determination of the section 6662 penalty is sustained to the extent warranted
by computations made in accordance with our holding for petitioner on the preneed accounting issue.
To reflect the foregoing,
An appropriate order will be issued, and decision will be entered under Rule 155.
1
Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the years in issue,
and Rule references are to the Tax Court Rules of Practice and Procedure.
2
The contractual notations were ineffective given their sham nature and the explicit directives of Massachusetts
law discussed below. See Comdisco, Inc. v. United States, 756 F.2d 569, 576 [55 AFTR 2d 85-1006] (7th Cir.
1985) (“in general, a contract entered in violation of statutory or regulatory law is unenforceable”).
3
The parties stipulated: “Of the pre-need funeral arrangements in existence on January 1, 1996, six have been
cancelled. Attached hereto and marked as Exhibits 19-J through 24-J are copies of petitioner’s business records
related to these pre-need arrangements.” However, the referenced exhibits bear contract dates spanning the years
1991 to 1999 and cancellation dates spanning years 1997 to 2003.
4
Presumably, because the Form 4549-A, Income Tax Examination Changes, contained in the record covers the 1996,
1997, and 1998 years, the audit would have begun after the September 15, 1999, date on which petitioner’s 1998
Federal income tax return appears to have been signed by the return preparer. The possibility exists, however, that
the 1998 or even the 1997 audit may have been added to an audit for 1996 already in progress. Nonetheless, as
explained in the text, we need not resolve or rely on such speculation here.
5
Accordingly, respondent considers Rev. Rul. 87-127, 1987-2 C.B. 156, dealing with the treatment of funeral
trusts as grantor trusts of the purchaser, inapplicable here.
6
Although the early case of Angelus Funeral Home v. Commissioner, 47 T.C. 391 (1967), affd. 407 F.2d 210
[23 AFTR 2d 69-673] (9th Cir. 1969), expressly dealt only with whether amounts should be excluded from income as
trust funds and did not consider a deposit rationale, the facts and result support our analysis here. In that case,
payments made under the mortuary’s revised preneed contracts were deemed taxable upon receipt (for lack of
trust), id. at 398, and would not appear to have been otherwise excludable as deposits. The Court noted that such
refunds as the mortuary gave were made “voluntarily”, and it “was not obligated to refund any moneys collected
pursuant to the terms of the contracts”. Id. at 394. Nor, in any event, does it appear that the mortuary raised
refundability as a defense to accrual of the income from the revised contracts. Id. at 397-299; see also Angelus
Funeral Home v. Commissioner, 407 F.2d at 213-214.
7
The notice also referenced substantial valuation misstatement as an additional alternative ground, see sec.
6662(b)(3), but since valuation was not a focus of this case, we disregard the apparent boilerplate reference.
8
We note that the phrasing of and figures recited in the parties’ stipulations concerning settled issues raise some
ambiguity regarding the precise nature of the settlement reached. However, it is clear that petitioner made multiple
concessions and that the parties do not intend for the Court to address the substantive matters covered by these
stipulations.
© 2010 Thomson Reuters/RIA. All rights reserved.
Week 3 Research Project (Set #1)
DeVry University Acct 429
TAX RESEARCH MEMORANDUM ASSIGNMENT 2
MegaCorp, Inc. purchased all of the assets of Little, Inc. As part of this acquisition, MegaCorp
also acquired some of Little’s liabilities. In particular, Little was involved in a particularly nasty
patent infringement case whereby another company (Ideas, Inc.) was alleging that Little had
violated its patents and, therefore, owed that company a substantial amount of money.
MegaCorp agreed that it would be legally responsible for any judgment that Little would have
to pay Ideas in the lawsuit. As part of this process, the opinions of various experts determined
that the likelihood that a significant contingent liability would arise from this obligation was
quite remote (between 0% and 5%).
Unfortunately for MegaCorp, a jury disagreed. After hearing evidence in the case, the jury
concluded that Little did indeed infringe Ideas’ patent and awarded Ideas $5 million in
damages. As agreed, MegaCorp paid Ideas the $5 million judgment and deducted this
payment as an ordinary and necessary business expense under § 162.
Upon audit, the IRS has disagreed with this characterization. The IRS reclassified the $5 million
payment as a capital expenditure under § 263 and disallow the deduction. MegaCorp has come
to you for advice. Is the IRS correct, or is MegaCorp entitled to the deduction?
COMPOSE A TAX FILE MEMORANDUM CONCERNING THIS ISSUE USING THESE FACTS AND THE
RESEARCH MATERIALS PROVIDED TO YOU IN THE NEXT FEW PAGES (30 POINTS).
Checkpoint Contents
Federal Library
Federal Source Materials
Code, Regulations, Committee Reports & Tax Treaties
Internal Revenue Code
Current Code
Subtitle A Income Taxes §§1-1563
Chapter 1 NORMAL TAXES AND SURTAXES §§1-1400U-3
Subchapter B Computation of Taxable Income §§61-291
Part VI ITEMIZED DEDUCTIONS FOR INDIVIDUALS AND CORPORATIONS §§161-199
§162 Trade or business expenses.
Internal Revenue Code
§ 162 Trade or business expenses.
(a) In general.
There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the
taxable year in carrying on any trade or business, including—
(1) a reasonable allowance for salaries or other compensation for personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging other than amounts which are
lavish or extravagant under the circumstances) while away from home in the pursuit of a trade or
business; and
(3) rentals or other payments required to be made as a condition to the continued use or possession,
for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking
title or in which he has no equity.
For purposes of the preceding sentence, the place of residence of a Member of Congress (including any
Delegate and Resident Commissioner) within the State, congressional district, or possession which he
represents in Congress shall be considered his home, but amounts expended by such Members within each
taxable year for living expenses shall not be deductible for income tax purposes in excess of $3,000. For
purposes of paragraph (2) , the taxpayer shall not be treated as being temporarily away from home during any
period of employment if such period exceeds 1 year. The preceding sentence shall not apply to any Federal
employee during any period for which such employee is certified by the Attorney General (or the designee
thereof) as traveling on behalf of the United States in temporary duty status to investigate or prosecute, or
provide support services for the investigation or prosecution of, a Federal crime.
(b) Charitable contributions and gifts excepted.
No deduction shall be allowed under subsection (a) for any contribution or gift which would be allowable as a
deduction under section 170 were it not for the percentage limitations, the dollar limitations, or the
requirements as to the time of payment, set forth in such section.
(c) Illegal bribes, kickbacks, and other payments.
(1) Illegal payments to government officials or employees.
No deduction shall be allowed under subsection (a) for any payment made, directly or indirectly, to an
official or employee of any government, or of any agency or instrumentality of any government, if the
payment constitutes an illegal bribe or kickback or, if the payment is to an official or employee of a
foreign government, the payment is unlawful under the Foreign Corrupt Practices Act of 1977. The
burden of proof in respect of the issue, for the purposes of this paragraph, as to whether a payment
constitutes an illegal bribe or kickback (or is unlawful under the Foreign Corrupt Practices Act of 1977)
shall be upon the Secretary to the same extent as he bears the burden of proof under section 7454
(concerning the burden of proof when the issue relates to fraud).
(2) Other illegal payments.
No deduction shall be allowed under subsection (a) for any payment (other than a payment described in
paragraph (1) ) made, directly or indirectly, to any person, if the payment constitutes an illegal bribe,
illegal kickback, or other illegal payment under any law of the United States, or under any law of a State
(but only if such State law is generally enforced), which subjects the payor to a criminal penalty or the
loss of license or privilege to engage in a trade or business. For purposes of this paragraph, a kickback
includes a payment in consideration of the referral of a client, patient, or customer. The burden of proof
in respect of the issue, for purposes of this paragraph, as to whether a payment constitutes an illegal
bribe, illegal kickback, or other illegal payment shall be upon the Secretary to the same extent as he
bears the burden of proof under section 7454 (concerning the burden of proof when the issue relates to
fraud).
(3) Kickbacks, rebates, and bribes under medicare and medicaid.
No deduction shall be allowed under subsection (a) for any kickback, rebate, or bribe made by any
provider of services, supplier, physician, or other person who furnishes items or services for which
payment is or may be made under the Social Security Act, or in whole or in part out of Federal funds
under a State plan approved under such Act, if such kickback, rebate, or bribe is made in connection
with the furnishing of such items or services or the making or receipt of such payments. For purposes of
this paragraph, a kickback includes a payment in consideration of the referral of a client, patient, or
customer.
(d) Capital contributions to Federal National Mortgage Association.
For purposes of this subtitle, whenever the amount of capital contributions evidenced by a share of stock
issued pursuant to section 303(c) of the Federal National Mortgage Association Charter Act ( 12 U.S.C., Sec.
1718 ) exceeds the fair market value of the stock as of the issue date of such stock, the initial holder of the
stock shall treat the excess as ordinary and necessary expenses paid or incurred during the taxable year in
carrying on a trade or business.
(e) Denial of deduction for certain lobbying and political expenditures.
(1) In general.
No deduction shall be allowed under subsection (a) for any amount paid or incurred in connection with—
(A) influencing legislation,
(B) participation in, or intervention in, any political campaign on behalf of (or in opposition to) any
candidate for public office,
(C) any attempt to influence the general public, or segments thereof, with respect to elections,
legislative matters, or referendums, or
(D) any direct communication with a covered executive branch official in an attempt to influence
the official actions or positions of such official.
(2) Exception for local legislation.
In the case of any legislation of any local council or similar governing body—
(A) paragraph (1)(A) shall not apply, and
(B) the deduction allowed by subsection (a) shall include all ordinary and necessary expenses
(including, but not limited to, traveling expenses described in subsection (a)(2) and the cost of
preparing testimony) paid or incurred during the taxable year in carrying on any trade or business—
(i) in direct connection with appearances before, submission of statements to, or sending
communications to the committees, or individual members, of such council or body with
respect to legislation or proposed legislation of direct interest to the taxpayer, or
(ii) in direct connection with communication of information between the taxpayer and an
organization of which the taxpayer is a member with respect to any such legislation or
proposed legislation which is of direct interest to the taxpayer and to such organization,
and that portion of the dues so paid or incurred with respect to any organization of which the
taxpayer is a member which is attributable to the expenses of the activities described in clauses
(i) and (ii) carried on by such organization.
(3) Application to dues of tax-exempt organizations.
No deduction shall be allowed under subsection (a) for the portion of dues or other similar amounts paid
by the taxpayer to an organization which is exempt from tax under this subtitle which the organization
notifies the taxpayer under section 6033(e)(1)(A)(ii) is allocable to expenditures to which paragraph (1)
applies.
(4) Influencing legislation.
For purposes of this subsection —
(A) In general. The term “influencing legislation” means any attempt to influence any legislation
through communication with any member or employee of a legislative body, or with any
government official or employee who may participate in the formulation of legislation.
(B) Legislation. The term “legislation” has the meaning given such term by section 4911(e)(2) .
(5) Other special rules.
(A) Exception for certain taxpayers. In the case of any taxpayer engaged in the trade or business
of conducting activities described in paragraph (1) , paragraph (1) shall not apply to expenditures
of the taxpayer in conducting such activities directly on behalf of another person (but shall apply
to payments by such other person to the taxpayer for conducting such activities).
(B) De minimis exception.
(i) In general. Paragraph (1) shall not apply to any in-house expenditures for any taxable
year if such expenditures do not exceed $2,000. In determining whether a taxpayer exceeds
the $2,000 limit under this clause, there shall not be taken into account overhead costs
otherwise allocable to activities described in paragraphs (1)(A) and (D) .
(ii) In-house expenditures. For purposes of clause (i) , the term “in-house expenditures”
means expenditures described in paragraphs (1)(A) and (D) other than—
(I) payments by the taxpayer to a person engaged in the trade or business of
conducting activities described in paragraph (1) for the conduct of such activities on
behalf of the taxpayer, or
(II) dues or other similar amounts paid or incurred by the taxpayer which are allocable
to activities described in paragraph (1) .
(C) Expenses incurred in connection with lobbying and political activities. Any amount paid or
incurred for research for, or preparation, planning, or coordination of, any activity described in
paragraph (1) shall be treated as paid or incurred in connection with such activity.
(6) Covered executive branch official.
For purposes of this subsection , the term “covered executive branch official” means—
(A) the President,
(B) the Vice President,
(C) any officer or employee of the White House Office of the Executive Office of the President,
and the 2 most senior level officers of each of the other agencies in such Executive Office, and
(D) (i) any individual serving in a position in level I of the Executive Schedule under section 5312
of title 5, United States Code , (ii) any other individual designated by the President as having
Cabinet level status, and (iii) any immediate deputy of an individual described in clause (i) or (ii) .
(7) Special rule for Indian tribal governments.
For purposes of this subsection , an Indian tribal government shall be treated in the same manner as a
local council or similar governing body.
(8) Cross reference.
For reporting requirements and alternative taxes related to this subsection , see section 6033(e) .
(f) Fines and penalties.
No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the
violation of any law.
(g) Treble damage payments under the antitrust laws.
If in a criminal proceeding a taxpayer is convicted of a violation of the antitrust laws, or his plea of guilty or
nolo contendere to an indictment or information charging such a violation is entered or accepted in such a
proceeding, no deduction shall be allowed under subsection (a) for two-thirds of any amount paid or incurred—
(1) on any judgment for damages entered against the taxpayer under section 4 of the Act entitled “An
Act to supplement existing laws against unlawful restraints and monopolies, and for other purposes”,
approved October 15, 1914 (commonly known as the Clayton Act), on account of such violation or any
related violation of the antitrust laws which occurred prior to the date of the final judgment of such
conviction, or
(2) in settlement of any action brought under such section 4 on account of such violation or related
violation.
The preceding sentence shall not apply with respect to any conviction or plea before January 1, 1970, or to
any conviction or plea on or after such date in a new trial following an appeal of a conviction before such
date.
(h) State legislators’ travel expenses away from home.
(1) In general.
For purposes of subsection (a) , in the case of any individual who is a State legislator at any time during
the taxable year and who makes an election under this subsection for the taxable year—
(A) the place of residence of such individual within the legislative district which he represented
shall be considered his home,
(B) he shall be deemed to have expended for living expenses (in connection with his trade or
business as a legislator) an amount equal to the sum of the amounts determined by multiplying
each legislative day of such individual during the taxable year by the greater of—
(i) the amount generally allowable with respect to such day to employees of the State of
which he is a legislator for per diem while away from home, to the extent such amount does
not exceed 110 percent of the amount described in clause (ii) with respect to such day, or
(ii) the amount generally allowable with respect to such day to employees of the executive
branch of the Federal Government for per diem while away from home but serving in the
United States, and
(C) he shall be deemed to be away from home in the pursuit of a trade or business on each
legislative day.
(2) Legislative days.
For purposes of paragraph (1) , a legislative day during any taxable year for any individual shall be any
day during such year on which—
(A) The legislature was in session (including any day in which the legislature was not in session for
a period of 4 consecutive days or less), or
(B) The legislature was not in session but the physical presence of the individual was formally
recorded at a meeting of a committee of such legislature.
(3) Election.
An election under this subsection for any taxable year shall be made at such time and in such manner as
the Secretary shall by regulations prescribe.
(4) Section not to apply to legislators who reside near capitol.
For taxable years beginning after December 31, 1980, this subsection shall not apply to any legislator
whose place of residence within the legislative district which he represents is 50 or fewer miles from the
capitol building of the State.
(i) Repealed.
(j) Certain foreign advertising expenses.
(1) In general.
No deduction shall be allowed under subsection (a) for any expenses of an advertisement carried by a
foreign broadcast undertaking and directed primarily to a market in the United States. This paragraph
shall apply only to foreign broadcast undertakings located in a country which denies a similar deduction
for the cost of advertising directed primarily to a market in the foreign country when placed with a
United States broadcast undertaking.
(2) Broadcast undertaking.
For purposes of paragraph (1) , the term “broadcast undertaking” includes (but is not limited to) radio
and television stations.
(k) Stock reacquisition expenses.
(1) In general.
Except as provided in paragraph (2) , no deduction otherwise allowable shall be allowed under this
chapter for any amount paid or incurred by a corporation in connection with the reacquisition of its
stock or of the stock of any related person (as defined in section 465(b)(3)(C) ).
(2) Exceptions.
Paragraph (1) shall not apply to—
(A) Certain specific deductions. Any—
(i) deduction allowable under section 163 (relating to interest),
(ii) deduction for amounts which are properly allocable to indebtedness and amortized over
the term of such indebtedness, or
(iii) deduction for dividends paid (within the meaning of section 561 ).
(B) Stock of certain regulated investment companies. Any amount paid or incurred in connection
with the redemption of any stock in a regulated investment company which issues only stock
which is redeemable upon the demand of the shareholder.
(l) Special rules for health insurance costs of self-employed individuals.
(1) Allowance of deduction.
(A) In general. In the case of an individual who is an employee within the meaning of section 401
(c)(1) , there shall be allowed as a deduction under this section an amount equal to the applicable
percentage of the amount paid during the taxable year for insurance which constitutes medical
care for the taxpayer, his spouse, and dependents.
(B) Applicable percentage. For purposes of subparagraph (A) , the applicable percentage shall be
determined under the following table:

For taxable years beginning The applicable
in calendar year — percentage is —
1999 through 2001 60
2002 70
2003 and thereafter 100.
(2) Limitations.
(A) Dollar amount. No deduction shall be allowed under paragraph (1) to the extent that the
amount of such deduction exceeds the taxpayer’s earned income (within the meaning of section
401(c) ) derived by the taxpayer from the trade or business with respect to which the plan
providing the medical care coverage is established.
(B) Other coverage. Paragraph (1) shall not apply to any taxpayer for any calendar month for
which the taxpayer is eligible to participate in any subsidized health plan maintained by any
employer of the taxpayer or of the spouse of the taxpayer. The preceding sentence shall be
applied separately with respect to—
(i) plans which include coverage for qualified long-term care services (as defined in section
7702B(c) ) or are qualified long-term care insurance contracts (as defined in section 7702B
(b) ), and
(ii) plans which do not include such coverage and are not such contracts.
(C) Long-term care premiums. In the case of a qualified long-term care insurance contract (as
defined in section 7702B(b) ), only eligible long-term care premiums (as defined in section 213(d)
(10) ) shall be taken into account under paragraph (1) .
(3) Coordination with medical deduction.
Any amount paid by a taxpayer for insurance to which paragraph (1) applies shall not be taken into
account in computing the amount allowable to the taxpayer as a deduction under section 213(a) .
(4) Deduction not allowed for self-employment tax purposes.
The deduction allowable by reason of this subsection shall not be taken into account in determining an
individual’s net earnings from self-employment (within the meaning of section 1402(a) ) for purposes of
chapter 2.
(5) Treatment of certain S corporation shareholders.
This subsection shall apply in the case of any individual treated as a partner under section 1372(a) ,
except that—
(A) for purposes of this subsection , such individual’s wages (as defined in section 3121 ) from the
S corporation shall be treated as such individual’s earned income (within the meaning of section
401(c)(1) ), and
(B) there shall be such adjustments in the application of this subsection as the Secretary may by
regulations prescribe.
(m) Certain excessive employee remuneration.
(1) In general.
In the case of any publicly held corporation, no deduction shall be allowed under this chapter for
applicable employee remuneration with respect to any covered employee to the extent that the amount
of such remuneration for the taxable year with respect to such employee exceeds $1,000,000.
(2) Publicly held corporation.
For purposes of this subsection, the term “publicly held corporation” means any corporation issuing any
class of common equity securities required to be registered under section 12 of the Securities Exchange
Act of 1934.
(3) Covered employee.
For purposes of this subsection, the term “covered employee” means any employee of the taxpayer if—
(A) as of the close of the taxable year, such employee is the chief executive officer of the
taxpayer or is an individual acting in such a capacity, or
(B) the total compensation of such employee for the taxable year is required to be reported to
shareholders under the Securities Exchange Act of 1934 by reason of such employee being among
the 4 highest compensated officers for the taxable year (other than the chief executive officer).
(4) Applicable employee remuneration.
For purposes of this subsection —
(A) In general. Except as otherwise provided in this paragraph, the term “applicable employee
remuneration” means, with respect to any covered employee for any taxable year, the aggregate
amount allowable as a deduction under this chapter for such taxable year (determined without
regard to this subsection ) for remuneration for services performed by such employee (whether or
not during the taxable year).
(B) Exception for remuneration payable on commission basis. The term “applicable employee
remuneration” shall not include any remuneration payable on a commission basis solely on account
of income generated directly by the individual performance of the individual to whom such
remuneration is payable.
(C) Other performance-based compensation. The term “applicable employee remuneration” shall
not include any remuneration payable solely on account of the attainment of one or more
performance goals, but only if—
(i) the performance goals are determined by a compensation committee of the board of
directors of the taxpayer which is comprised solely of 2 or more outside directors,
(ii) the material terms under which the remuneration is to be paid, including the performance
goals, are disclosed to shareholders and approved by a majority of the vote in a separate
shareholder vote before the payment of such remuneration, and
(iii) before any payment of such remuneration, the compensation committee referred to in
clause (i) certifies that the performance goals and any other material terms were in fact
satisfied.
(D) Exception for existing binding contracts. The term “applicable employee remuneration” shall not
include any remuneration payable under a written binding contract which was in effect on
February 17, 1993, and which was not modified thereafter in any material respect before such
remuneration is paid.
(E) Remuneration. For purposes of this paragraph , the term “remuneration” includes any
remuneration (including benefits) in any medium other than cash, but shall not include—
(i) any payment referred to in so much of section 3121(a)(5) as precedes subparagraph (E)
thereof , and
(ii) any benefit provided to or on behalf of an employee if at the time such benefit is
provided it is reasonable to believe that the employee will be able to exclude such benefit
from gross income under this chapter.
For purposes of clause (i) , section 3121(a)(5) shall be applied without regard to section 3121(v)
(1) .
(F) Coordination with disallowed golden parachute payments. The dollar limitation contained in
paragraph (1) shall be reduced (but not below zero) by the amount (if any) which would have
been included in the applicable employee remuneration of the covered employee for the taxable
year but for being disallowed under section 280G .
(G) Coordination with excise tax on specified stock compensation. The dollar limitation contained in
paragraph (1) with respect to any covered employee shall be reduced (but not below zero) by the
amount of any payment (with respect to such employee) of the tax imposed by section 4985
directly or indirectly by the expatriated corporation (as defined in such section ) or by any member
of the expanded affiliated group (as defined in such section ) which includes such corporation.
(5) Special rule for application to employers participating in the troubled assets relief program.
(A) In general. In the case of an applicable employer, no deduction shall be allowed under this
chapter—
(i) in the case of executive remuneration for any applicable taxable year which is
attributable to services performed by a covered executive during such applicable taxable
year, to the extent that the amount of such remuneration exceeds $500,000, or
(ii) in the case of deferred deduction executive remuneration for any taxable year for
services performed during any applicable taxable year by a covered executive, to the extent
that the amount of such remuneration exceeds $500,000 reduced (but not below zero) by
the sum of—
(I) the executive remuneration for such applicable taxable year, plus
(II) the portion of the deferred deduction executive remuneration for such services
which was taken into account under this clause in a preceding taxable year.
(B) Applicable employer. For purposes of this paragraph —
(i) In general. Except as provided in clause (ii) , the term “applicable employer” means any
employer from whom 1 or more troubled assets are acquired under a program established by
the Secretary under section 101(a) of the Emergency Economic Stabilization Act of 2008 if
the aggregate amount of the assets so acquired for all taxable years exceeds $300,000,000.
(ii) Disregard of certain assets sold through direct purchase. If the only sales of troubled
assets by an employer under the program described in clause (i) are through 1 or more direct
purchases (within the meaning of section 113(c) of the Emergency Economic Stabilization
Act of 2008), such assets shall not be taken into account under clause (i) in determining
whether the employer is an applicable employer for purposes of this paragraph .
(iii) Aggregation rules. Two or more persons who are treated as a single employer under
subsection (b) or (c) of section 414 shall be treated as a single employer, except that in
applying section 1563(a) for purposes of either such subsection, paragraphs (2) and (3)
thereof shall be disregarded.
(C) Applicable taxable year. For purposes of this paragraph , the term “applicable taxable year”
means, with respect to any employer—
(i) the first taxable year of the employer—
(I) which includes any portion of the period during which the authorities under section
101(a) of the Emergency Economic Stabilization Act of 2008 are in effect (determined
under section 120 thereof), and
(II) in which the aggregate amount of troubled assets acquired from the employer
during the taxable Year pursuant to such authorities (other than assets to which
subparagraph (B)(ii) applies), when added to the aggregate amount so acquired for all
preceding taxable years, exceeds $300,000,000, and
(ii) any subsequent taxable year which includes any portion of such period.
(D) Covered executive. For purposes of this paragraph —
(i) In general. The term “covered executive” means, with respect to any applicable taxable
year, any employee—
(I) who, at any time during the portion of the taxable year during which the authorities
under section 101(a) of the Emergency Economic Stabilization Act of 2008 are in
effect (determined under section 120 thereof), is the chief executive officer of the
applicable employer or the chief financial officer of the applicable employer, or an
individual acting in either such capacity, or
(II) who is described in clause (ii) .
(ii) Highest compensated employees. An employee is described in this clause if the employee
is 1 of the 3 highest compensated officers of the applicable employer for the taxable year
(other than an individual described in clause (i)(I) ), determined—
(I) on the basis of the shareholder disclosure rules for compensation under the
Securities Exchange Act of 1934 (without regard to whether those rules apply to the
employer), and
(II) by only taking into account employees employed during the portion of the taxable
year described in clause (i)(I) .
(iii) Employee remains covered executive. If an employee is a covered executive with
respect to an applicable employer for any applicable taxable year, such employee shall be
treated as a covered executive with respect to such employer for all subsequent applicable
taxable years and for all subsequent taxable years in which deferred deduction executive
remuneration with respect to services performed in all such applicable taxable years would
(but for this paragraph) be deductible.
(E) Executive remuneration. For purposes of this paragraph , the term “executive remuneration”
means the applicable employee remuneration of the covered executive, as determined under
paragraph (4) without regard to subparagraphs (B), (C), and (D) thereof. Such term shall not
include any deferred deduction executive remuneration with respect to services performed in a
prior applicable taxable year.
(F) Deferred deduction executive remuneration. For purposes of this paragraph , the term
“deferred deduction executive remuneration” means remuneration which would be executive
remuneration for services performed in an applicable taxable year but for the fact that the
deduction under this chapter (determined without regard to this paragraph ) for such remuneration
is allowable in a subsequent taxable year.
(G) Coordination. Rules similar to the rules of subparagraphs (F) and (G) of paragraph (4) shall
apply for purposes of this paragraph .
(H) Regulatory authority. The Secretary may prescribe such guidance, rules, or regulations as are
necessary to carry out the purposes of this paragraph and the Emergency Economic Stabilization
Act of 2008, including the extent to which this paragraph applies in the case of any acquisition,
merger, or reorganization of an applicable employer.
Caution: Subsecs. (n) and (o) , following, are effective for services provided after 2/2/93, and on or before
12/31/95. Subsec. (o) has been redesignated as subsec. (p) by Sec. 1204(a) of P.L. 105-34. For subsec. (p) see
below. For effective date of the provisions of Sec. 1204(a) of P.L. 105-34, see notes following this Code Sec.
(n) Special rule for certain group health plans.
(1) In general.
No deduction shall be allowed under this chapter to an employer for any amount paid or incurred in
connection with a group health plan if the plan does not reimburse for inpatient hospital care services
provided in the State of New York—
(A) except as provided in subparagraphs (B) and (C) , at the same rate as licensed commercial
insurers are required to reimburse hospitals for such services when such reimbursement is not
through such a plan,
(B) in the case of any reimbursement through a health maintenance organization, at the same rate
as health maintenance organizations are required to reimburse hospitals for such services for
individuals not covered by such a plan (determined without regard to any government-supported
individuals exempt from such rate), or
(C) in the case of any reimbursement through any corporation organized under Article 43 of the
New York State Insurance Law, at the same rate as any such corporation is required to reimburse
hospitals for such services for individuals not covered by such a plan.
(2) State law exception.
Paragraph (1) shall not apply to any group health plan which is not required under the laws of the State
of New York (determined without regard to this subsection or other provisions of Federal law) to
reimburse at the rates provided in paragraph (1) .
(3) Group health plan.
For purposes of this subsection , the term “group health plan” means a plan of, or contributed to by, an
employer or employee organization (including a self-insured plan) to provide health care (directly or
otherwise) to any employee, any former employee, the employer, or any other individual associated or
formerly associated with the employer in a business relationship, or any member of their family.
(o) Treatment of certain expenses of rural mail carriers.
(1) General rule.
In the case of any employee of the United States Postal Service who performs services involving the
collection and delivery of mail on a rural route and who receives qualified reimbursements for the
expenses incurred by such employee for the use of a vehicle in performing such services—
(A) the amount allowable as a deduction under this chapter for the use of a vehicle in performing
such services shall be equal to the amount of such qualified reimbursements; and
(B) such qualified reimbursements shall be treated as paid under a reimbursement or other expense
allowance arrangement for purposes of section 62(a)(2)(A) (and section 62(c) shall not apply to
such qualified reimbursements).
(2) Special rule where expenses exceed reimbursements.
Notwithstanding paragraph (1)(A) , if the expenses incurred by an employee for the use of a vehicle in
performing services described in paragraph (1) exceed the qualified reimbursements for such expenses,
such excess shall be taken into account in computing the miscellaneous itemized deductions of the
employee under section 67 .
(3) Definition of qualified reimbursements.
For purposes of this subsection , the term “qualified reimbursements” means the amounts paid by the
United States Postal Service to employees as an equipment maintenance allowance under the 1991
collective bargaining agreement between the United States Postal Service and the National Rural Letter
Carriers’ Association. Amounts paid as an equipment maintenance allowance by such Postal Service
under later collective bargaining agreements that supersede the 1991 agreement shall be considered
qualified reimbursements if such amounts do not exceed the amounts that would have been paid under
the 1991 agreement, adjusted for changes in the Consumer Price Index (as defined in section 1(f)(5) )
since 1991.
(p) Treatment of expenses of members of reserve component of Armed Forces of the United States.
For purposes of subsection (a)(2) , in the case of an individual who performs services as a member of a
reserve component of the Armed Forces of the United States at any time during the taxable year, such
individual shall be deemed to be away from home in the pursuit of a trade or business for any period during
which such individual is away from home in connection with such service.
(q) Cross reference.
(1) For special rule relating to expenses in connection with subdividing real property for sale, see section
1237 .
(2) For special rule relating to the treatment of payments by a transferee of a franchise, trademark, or
trade name, see section 1253 .
(3) For special rules relating to—
(A) funded welfare benefit plans, see section 419 , and
(B) deferred compensation and other deferred benefits, see section 404 .
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Federal Source Materials
Code, Regulations, Committee Reports & Tax Treaties
Internal Revenue Code
Current Code
Subtitle A Income Taxes §§1-1563
Chapter 1 NORMAL TAXES AND SURTAXES §§1-1400U-3
Subchapter B Computation of Taxable Income §§61-291
Part IX ITEMS NOT DEDUCTIBLE §§261-280H
§263 Capital expenditures.
Internal Revenue Code
§ 263 Capital expenditures.
(a) General rule.
No deduction shall be allowed for—
(1) Any amount paid out for new buildings or for permanent improvements or betterments made to
increase the value of any property or estate. This paragraph shall not apply to—
(A) expenditures for the development of mines or deposits deductible under section 616 ,
(B) research and experimental expenditures deductible under section 174 ,
(C) soil and water conservation expenditures deductible under section 175 ,
(D) expenditures by farmers for fertilizer, etc., deductible under section 180 ,
(E) expenditures for removal of architectural and transportation barriers to the handicapped and
elderly which the taxpayer elects to deduct under section 190 ,
(F) expenditures for tertiary injectants with respect to which a deduction is allowed under section
193 ,
(G) expenditures for which a deduction is allowed under section 179 ,
(H) expenditures for which a deduction is allowed under section 179A ,
(I) expenditures for which a deduction is allowed under section 179B ,
(J) expenditures for which a deduction is allowed under section 179C ,
(K) expenditures for which a deduction is allowed under section 179D , or
(L) expenditures for which a deduction is allowed under section 179E .
(2) Any amount expended in restoring property or in making good the exhaustion thereof for which an
allowance is or has been made.
(b) Repealed.
(c) Intangible drilling and development costs in the case of oil and gas wells and geothermal wells.
Notwithstanding subsection (a) , and except as provided in subsection (i) , regulations shall be prescribed by
the Secretary under this subtitle corresponding to the regulations which granted the option to deduct as
expenses intangible drilling and development costs in the case of oil and gas wells and which were recognized
and approved by the Congress in House Concurrent Resolution 50, Seventy-ninth Congress. Such regulations
shall also grant the option to deduct as expenses intangible drilling and development costs in the case of wells
drilled for any geothermal deposit (as defined in section 613(e)(2) ) to the same extent and in the same
manner as such expenses are deductible in the case of oil and gas wells. This subsection shall not apply with
respect to any costs to which any deduction is allowed under section 59(e) or 291 .
(d) Expenditures in connection with certain railroad rolling stock.
In the case of expenditures in connection with the rehabilitation of a unit of railroad rolling stock (except a
locomotive) used by a domestic common carrier by railroad which would, but for this subsection , be properly
chargeable to capital account, such expenditures, if during any 12-month period they do not exceed an
amount equal to 20 percent of the basis of such unit in the hands of the taxpayer, shall, at the election of the
taxpayer, be treated (notwithstanding subsection (a) ) as deductible repairs under section 162 or 212 . An
election under this subsection shall be made for any taxable year at such time and in such manner as the
Secretary prescribes by regulations. An election may not be made under this subsection for any taxable year
to which an election under subsection (e) applies to railroad rolling stock (other than locomotives).
(e) Repealed.
(f) Railroad ties.
In the case of a domestic common carrier by rail (including a railroad switching or terminal company) which
uses the retirement-replacement method of accounting for depreciation of its railroad track, expenditures for
acquiring and installing replacement ties of any material (and fastenings related to such ties) shall be accorded
the same tax accounting treatment as expenditures for replacement ties of wood (and fastenings related to
such ties).
(g) Certain interest and carrying costs in the case of straddles.
(1) General rule.
No deduction shall be allowed for interest and carrying charges properly allocable to personal property
which is part of a straddle (as defined in section 1092(c) ). Any amount not allowed as a deduction by
reason of the preceding sentence shall be chargeable to the capital account with respect to the
personal property to which such amount relates.
(2) Interest and carrying charges defined.
For purposes of paragraph (1) , the term “interest and carrying charges” means the excess of—
(A) the sum of—
(i) interest on indebtedness incurred or continued to purchase or carry the personal
property, and
(ii) all other amounts (including charges to insure, store, or transport the personal property)
paid or incurred to carry the personal property, over
(B) the sum of—
(i) the amount of interest (including original issue discount) includible in gross income for the
taxable year with respect to the property described in subparagraph (A) ,
(ii) any amount treated as ordinary income under section 1271(a)(3)(A) , 1276 , or 1281(a)
with respect to such property for the taxable year,
(iii) the excess of any dividends includible in gross income with respect to such property for
the taxable year over the amount of any deduction allowable with respect to such dividends
under section 243 , 244 , or 245 , and
(iv) any amount which is a payment with respect to a security loan (within the meaning of
section 512(a)(5) ) includible in gross income with respect to such property for the taxable
year.
For purposes of subparagraph (A) , the term “interest” includes any amount paid or incurred in connection with
personal property used in a short sale.
(3) Exception for hedging transactions.
This subsection shall not apply in the case of any hedging transaction (as defined in section 1256(e) ).
(4) Application with other provisions.
(A) Subsection (c) . In the case of any short sale, this subsection shall be applied after
subsection (h) .
(B) Section 1277 or 1282 . In the case of any obligation to which section 1277 or 1282 applies,
this subsection shall be applied after section 1277 or 1282 .
(h) Payments in lieu of dividends in connection with short sales.
(1) In general.
If—
(A) a taxpayer makes any payment with respect to any stock used by such taxpayer in a short
sale and such payment is in lieu of a dividend payment on such stock, and
(B) the closing of such short sale occurs on or before the 45th day after the date of such short
sale,
then no deduction shall be allowed for such payment. The basis of the stock used to close the short sale shall
be increased by the amount not allowed as a deduction by reason of the preceding sentence.
(2) Longer period in case of extraordinary dividends.
If the payment described in paragraph (1)(A) is in respect of an extraordinary dividend, paragraph (1)(B)
shall be applied by substituting “the day 1 year after the date of such short sale” for “the 45th day after
the date of such short sale”.
(3) Extraordinary dividend.
For purposes of this subsection , the term “extraordinary dividend” has the meaning given to such term
by section 1059(c) ; except that such section shall be applied by treating the amount realized by the
taxpayer in the short sale as his adjusted basis in the stock.
(4) Special rule where risk of loss diminished.
The running of any period of time applicable under paragraph (1)(B) (as modified by paragraph (2) ) shall
be suspended during any period in which—
(A) the taxpayer holds, has an option to buy, or is under a contractual obligation to buy,
substantially identical stock or securities, or
(B) under regulations prescribed by the Secretary, a taxpayer has diminished his risk of loss by
holding 1 or more other positions with respect to substantially similar or related property.
(5) Deduction allowable to extent of ordinary income from amounts paid by lending broker for
use of collateral.
(A) In general. Paragraph (1) shall apply only to the extent that the payments or distributions with
respect to any short sale exceed the amount which—
(i) is treated as ordinary income by the taxpayer, and
(ii) is received by the taxpayer as compensation for the use of any collateral with respect to
any stock used in such short sale.
(B) Exception not to apply to extraordinary dividends. Subparagraph (A) shall not apply if one or
more payments or distributions is in respect of an extraordinary dividend.
(6) Application of this subsection with subsection (g) .
In the case of any short sale, this subsection shall be applied before subsection (g) .
(i) Special rules for intangible drilling and development costs incurred outside the United States.
In the case of intangible drilling and development costs paid or incurred with respect to an oil, gas, or
geothermal well located outside the United States—
(1) subsection (c) shall not apply, and
(2) such costs shall—
(A) at the election of the taxpayer, be included in adjusted basis for purposes of computing the
amount of any deduction allowable under section 611 (determined without regard to section 613 ),
or
(B) if subparagraph (A) does not apply, be allowed as a deduction ratably over the 10-taxable
year period beginning with the taxable year in which such costs were paid or incurred.
This subsection shall not apply to costs paid or incurred with respect to a nonproductive well.
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Federal Tax Decisions
American Federal Tax Reports
American Federal Tax Reports (Prior Years)
1992
AFTR 2d Vol. 69
69 AFTR 2d 92-705 – 69 AFTR 2d 92-553
INDOPCO, INC. v. COMM., 69 AFTR 2d 92-694 (503 U.S. 79, 112 S.Ct. 1039), Code Sec(s) 162; 263,
(S Ct), 02/26/1992
American Federal Tax Reports
INDOPCO, INC. v. COMM., Cite as 69 AFTR 2d 92-694 (503 U.S. 79, 112 S.Ct.
1039), 02/26/1992 , Code Sec(s) 162
INDOPCO, INC., PETITIONER v. COMMISSIONER of Internal Revenue, RESPONDENT.
Case Information:
HEADNOTE
1. Business expenses—Ordinary and necessary. Taxpayer couldn’t deduct investment banking, legal, and other
fees incurred in friendly takeover as ordinary and necessary business expenses. Court’s holding in Commissioner v.
Lincoln Savings & Loan Assn., 403 US 345, 27 AFTR2d 71-1542, didn’t establish exclusive test for
capitalization of expenditures under IRC §263 only when expenses created or enhanced a separate asset. The
true test of current deductibility depends on the duration and extent of the benefits realized by the taxpayer, and
here, the fees related more to the corporation’s permanent betterment than to its daily business.
Reference(s): ¶ 1625.010(10) ; ¶ 2635.17(85) . Code Sec. 162 ; Code Sec. 263 .
OPINION
Certiorari to the United States Court of Appeals for the Third Circuit. Syllabus On its 1978 federal income tax return,
petitioner corporation claimed a deduction for certain investment banking fees and expenses that it incurred during a
friendly acquisition in which it was transformed from a publicly held, freestanding corporation into a wholly owned
subsidiary. After respondent Commissioner disallowed the claim, petitioner sought reconsideration in the Tax Court,
adding to its claim deductions for legal fees and other acquisition-related expenses. The Tax Court ruled that
because long-term benefits accrued to petitioner from the acquisition, the expenditures were capital in nature and
not deductible under §162(a) of the Internal Revenue Code as “ordinary and necessary” business expenses. The
Court of Appeals affirmed, rejecting petitioner’s argument that, because the expenses did not “create or enhance …
a separate and distinct additional asset,” see Commissioner v. Lincoln Savings & Loan Assn., 403 U.S. 345, 354, [
27 AFTR2d 71-1542] they could not be capitalized under §263 of the Code. Held: Petitioner’s expenses do not
qualify for deduction under §162(a). Deductions are exceptions to the norm of capitalization and are allowed only if
there is clear provision for them in the Code and the taxpayer has met the burden of showing a right to the
deduction. Commissioner v. Lincoln Savings & Loan Assn., supra, holds simply that the creation of a separate and
Code Sec(s): 162
Court Name: U.S. Supreme Court,
Docket No.: No. 90-1278,
Date
Decided: 02/26/1992
Prior History: Court of Appeals, 66 AFTR2d 90-5844 ( 918 F.2d 426), affirming 93 TC 67
(No. 7), affirmed.
Tax Year(s): Year 1978.
Disposition: Decision for Govt. 503 U.S. 79, 112 S.Ct. 1039.
Cites: 69 AFTR 2d 92-694, 112 S Ct 1039, 117 L Ed 2d 226, 92-1 USTC P 50113.
distinct asset may be a sufficient condition for classification as a capital expenditure, not that it is a prerequisite to
such classification. Nor does Lincoln Savings prohibit reliance on future benefit as means of distinguishing an ordinary
business expense from a capital expenditure. Although the presence of an incidental future benefit may not warrant
capitalization, a taxpayer’s realization of benefits beyond the year in which the expenditure is incurred is important in
determining whether the appropriate [pg. 92-695] tax treatment is immediate deduction or capitalization. The record
in the instant case amply supports the lower courts’ findings that the transaction produced significant benefits to
petitioner extending beyond the tax year in question.
918 F.2d 426, [ 66 AFTR2d 90-5844] affirmed.
BLACKMUN, J., delivered the opinion for a unanimous Court.
Judge: Justice BLACKMUN delivered the opinion of the Court.
In this case we must decide whether certain professional expenses incurred by a target corporation in the course of
a friendly takeover are deductible by that corporation as “ordinary and necessary” business expenses under §162(a)
of the federal Internal Revenue Code.
I
Most of the relevant facts are stipulated. See App. 12, 149. Petitioner INDOPCO, Inc., formerly named National
Starch and Chemical Corporation and hereinafter referred to as National Starch, is a Delaware corporation that
manufactures and sells adhesives, starches, and specialty chemical products. In October 1977, representatives of
Unilever United States, Inc., also a Delaware corporation (Unilever), 1 expressed interest in acquiring National
Starch, which was one of its suppliers, through a friendly transaction. National Starch at the time had outstanding
over 6,563,000 common shares held by approximately 3700 shareholders. The stock was listed on the New York
Stock Exchange. Frank and Anna Greenwall were the corporation’s largest shareholders and owned approximately
14.5% of the common. The Greenwalls, getting along in years and concerned about their estate plans, indicated
that they would transfer their shares to Unilever only if a transaction tax-free for them could be arranged.
Lawyers representing both sides devised a “reverse subsidiary cash merger” that they felt would satisfy the
Greenwalls’ concerns. Two new entities would be created — National Starch and Chemical Holding Corp. (Holding), a
subsidiary of Unilever, and NSC Merger, Inc., a subsidiary of Holding that would have only a transitory existence. In
an exchange specifically designed to be tax-free under §351 of the Internal Revenue Code, 26 U.S.C. §351,
Holding would exchange one share of its nonvoting preferred stock for each share of National Starch common that it
received from National Starch shareholders. Any National Starch common that was not so exchanged would be
converted into cash in a merger of NSC Merger, Inc., into National Starch.
In November 1977, National Starch’s directors were formally advised of Unilever’s interest and the proposed
transaction. At that time, Debevoise, Plimpton, Lyons & Gates, National Starch’s counsel, told the directors that
under Delaware law they had a fiduciary duty to ensure that the proposed transaction would be fair to the
shareholders. National Starch thereupon engaged the investment banking firm of Morgan Stanley & Co., Inc., to
evaluate its shares, to render a fairness opinion, and generally to Help in the event of the emergence of a hostile
tender offer.
Although Unilever originally had suggested a price between $65 and $70 per share, negotiations resulted in a final
offer of $73.50 per share, a figure Morgan Stanley found to be fair. Following approval by National Starch’s board
and the issuance of a favorable private ruling from the Internal Revenue Service that the transaction would be taxfree under §351 for those National Starch shareholders who exchanged their stock for Holding preferred, the
transaction was consummated in August 1978. 2
Morgan Stanley charged National Starch a fee of $2,200,000, along with $7,586 for out-of-pocket expenses and
$18,000 for legal fees. The Debevoise firm charged National Starch $490,000, along with $15,069 for out-of-pocket
expenses. National Starch also incurred expenses aggregating $150,962 for miscellaneous items — such as
accounting, printing, proxy solicitation, and Securities and Exchange Commission fees — in connection with the
transaction. No issue is raised as to the propriety or reasonableness of these charges.
On its federal income tax return for its short taxable year ended August 15, 1978, National Starch claimed a
deduction for the $2,225,586 paid to Morgan Stanley, but did not deduct the $505,069 paid to Debevoise or the
other expenses. Upon audit, the Commissioner of Intrnal Revenue disallowed the claimed deduction and [pg. 92-696]
issued a notice of deficiency. Petitioner sought redetermination in the United States Tax Court, asserting, however,
not only the right to deduct the investment banking fees and expenses but, as well, the legal and miscellaneous
expenses incurred.
The Tax Court, in an unreviewed decision, ruled that the expenditures were capital in nature and therefore not
deductible under §162(a) in the 1978 return as “ordinary and necessary expenses.” National Starch and Chemical
Corp. v. Commissioner, 93 T.C. 67 (1989). The court based its holding primarily on the long-term benefits that
accrued to National Starch from the Unilever acquisition. Id., at 75. The United States Court of Appeals for the Third
Circuit affirmed, upholding the Tax Court’s findings that “both Unilever’s enormous resources and the possibility of
synergy arising from the transaction served the long-term betterment of National Starch.” National Starch and
Chemical Corp. v. Commissioner, 918 F.2d 426, 432-433 [ 66 AFTR2d 90-5844] (1990). In so doing, the Court
of Appeals rejected National Starch’s contention that, because the disputed expenses did not “create or enhance …
a separate and distinct additional asset,” see Commissioner v. Lincoln Savings & Loan Assn., 403 U.S. 345, 354 [
27 AFTR2d 71-1542] (1971), they could not be capitalized and therefore were deductible under §162(a). 918
F.2d, at 428-431. We granted certiorari to resolve a perceived conflict on the issue among the Courts of Appeals. 3
__ U.S. __ (1991).
II
[1] Section 162(a) of the Internal Revenue Code allows the deduction of “all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business.” 26 U.S.C. §162(a). In
contrast, §263 of the Code allows no deduction for a capital expenditure — an “amount paid out for new buildings or
for permanent improvements or betterments made to increase the value of any property or estate.” 26 U.S.C.
section 263(a)(1). The primary effect of characterizing a payment as either a business expense or a capital
expenditure concerns the timing of the taxpayer’s cost recovery: While business expenses are currently deductible,
a capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no specific
asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. See 26 U.S.C. §§167(a)
and 336(a); Treas. Reg. §1.167(a), 26 CFR §1.167(a) (1991). Through provisions such as these, the Code endeavors
to match expenses with the revenues of the taxable period to which they are properly attributable, thereby resulting
in a more accurate calculation of net income for tax purposes. See, e.g., Commissioner v. Idaho Power Co., 418
U.S. 1, 16 [ 34 AFTR2d 74-5244] (1974); Ellis Banking Corp. v. Commissioner, 688 F.2d 1376, 1379 [ 50
AFTR2d 82- 5909] (CA11 1982), cert. denied, 463 U.S. 1207 (1983).
In exploring the relationship between deductions and capital expenditures, this Court has noted the “familiar rule”
that “an income tax deduction is a matter of legislative grace and that the burden of clearly showing the right to the
claimed deduction is on the taxpayer.” Interstate Transit Lines v. Commissioner, 319 U.S. 590, 593 [ 30 AFTR
1310] (1943); Deputy v. Du Pont, 308 U.S. 488, 493 [ 23 AFTR 808] (1940); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 [ 13 AFTR 1180] (1934). The notion that deductions are exceptions to the norm
of capitalization finds support in various aspects of the Code. Deductions are specifically enumerated and thus are
subject to disallowance in favor of capitalization. See §§161 and 261. Nondeductible capital expenditures, by
contrast, are not exhaustively enumerated in the Code; rather than providing a “complete list of nondeductible
expenditures,” Lincoln Savings, 403 U.S., at 358, §263 serves as a general means of distinguishing capital
expenditures from current expenses. See Commissioner v. Idaho Power Co., 418 U.S., at 16. For these reasons,
deductions are strictly construed and allowed only “as there is a clear provision therefor.” New Colonial Ice Co. v.
Helvering, 292 U.S., at [pg. 92-697] 440; Deputy v. Du Pont, 308 U.S., at 493. 4
The Court also has examined the interrelationship between the Code’s business expense and capital expenditure
provisions. 5 In so doing, it has had occasion to parse §162(a) and explore certain of its requirements. For example,
in Lincoln Savings, we determined that, to qualify for deduction under §162(a), “an item must (1) be ‘paid or incurred
during the taxable year,’ (2) be for ‘carrying on any trade or business,’ (3) be an ‘expense,’ (4) be a ‘necessary’
expense, and (5) be an ‘ordinary’ expense.” 403 U.S., at 352. See also Commissioner v. Tellier, 383 U.S. 687, 689
[ 17 AFTR2d 633] (1966) (the term “necessary” imposes “only the minimal requirement that the expense be
‘appropriate and helpful’ for ‘the development of the [taxpayer’s] business,’ ” quoting Welch v. Helvering, 290
U.S. 111, 113 [ 12 AFTR 1456] (1933)); Deputy v. Du Pont, 308 U.S. 488, 495 [ 23 AFTR 808] (1940) (to
qualify as “ordinary,” the expense must relate to a transaction “of common or frequent occurrence in the type of
business involved”). The Court has recognized, however, that the “decisive distinctions” between current expenses
and capital expenditures “are those of degree and not of kind,” Welch v. Helvering, 290 U.S., at 114, and that
because each case “turns on its special facts,” Deputy v. Du Pont, 308 U.S., at 496, the cases sometimes appear
difficult to harmonize. See Welch v. Helvering, 290 U.S., at 116.
National Starch contends that the decision in Lincoln Savings changed these familiar backdrops and announced an
exclusive test for identifying capital expenditures, a test in which “creation or enhancement of an asset” is a
prerequisite to capitalization, and deductibility under §162(a) is the rule rather than the exception. Brief for
Petitioner 16. We do not agree, for we conclude that National Starch has overread Lincoln Savings.
In Lincoln Savings, we were asked to decide whether certain premiums, required by federal statute to be paid by a
savings and loan association to the Federal Savings and Loan Insurance Corporation (FSLIC), were ordinary and
necessary expenses under §162(a), as Lincoln Savings argued and the Court of Appeals had held, or capital
expenditures under §263, as the Commissioner contended. We found that the “additional” premiums, the purpose of
which was to provide FSLIC with a secondary reserve fund in which each insured institution retained a pro rata
interest recoverable in certain situations, “serv[e] to create or enhance for Lincoln what is essentially a separate
and distinct additional asset.” 403 U.S., at 354. “[A]s an inevitable consequence,” we concluded, “the payment is
capital in nature and not an expense, let alone an ordinary expense, deductible under §162(a).” Ibid.
Lincoln Savings stands for the simple proposition that a taxpayer’s expenditure that “serves to create or enhance …
a separate and distinct” asset should be capitalized under §263. It by no means follows, however, that only
expenditures that create or enhance separate and distinct assets are to be capitalized under §263. We had no
occasion in Lincoln Savings to consider the tax treatment of expenditures that, unlike the additional premiums at
issue there, did not create or enhance a specific asset, and thus the case cannot be read to preclude capitalization
in other circumstances. In [pg. 92-698] short, Lincoln Savings holds that the creation of a separate and distinct
asset well may be a sufficient but not a necessary condition to classification as a capital expenditure. See General
Bancshares Corp. v. Commissioner, 326 F.2d 712, 716 [ 13 AFTR2d 549] (CA8) (although expenditures may
not “resul[t] in the acquisition or increase of a corporate asset, … these expenditures are not, because of that fact,
deductible as ordinary and necessary business expenses”), cert. denied, 379 U.S. 832 (1964).
Nor does our statement in Lincoln Savings, 405 U.S., at 354, that “the presence of an ensuing benefit that may
have some future aspect is not controlling” prohibit reliance on future benefit as a means of distinguishing an
ordinary business expense from a capital expenditure. 6 Although the mere presence of an incidental future benefit —
“some future aspect” — may not warrant capitalization, a taxpayer’s realization of benefits beyond the year in which
the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is
immediate deduction or capitalization. See United States v. Mississippi Chemical Corp., 405 U.S. 298, 310 [
29 AFTR2d 72-671] (1972) (expense that “is of value in more than one taxable year” is a nondeductible capital
expenditure); Central Texas Savings & Loan Assn. v. United States, 731 F.2d 1181, 1183 [ 53 AFTR2d 84-1474]
(CA5 1984) (“While the period of the benefits may not be controlling in all cases, it nonetheless remains a prominent,
if not predominant, characteristic of a capital item.”). Indeed, the text of the Code’s capitalization provision, §263(a)
(1), which refers to “permanent improvements or betterments,” itself envisions an inquiry into the duration and
extent of the benefits realized by the taxpayer.
III
In applying the foregoing principles to the specific expenditures at issue in this case, we conclude that National
Starch has not demonstrated that the investment banking, legal, and other costs it incurred in connection with
Unilever’s acquisition of its shares are deductible as ordinary and necessary business expenses under §162(a).
Although petitioner attempts to dismiss the benefits that accrued to National Starch from the Unilever acquisition as
“entirely speculative” or “merely incidental,” Brief for Petitioner 39-40, the Tax Court’s and the Court of Appeals’
findings that the transaction produced significant benefits to National Starch that extended beyond the tax year in
question are amply supported by the record. For example, in commenting on the merger with Unilever, National
Starch’s 1978 “Progress Report” observed that the company would “benefit greatly from the availability of Unilever’s
enormous resources, especially in the area of basic technology.” App. 43. See also id., at 46 (Unilever “provides new
opportunities and resources”). Morgan Stanley’s report to the National Starch board concerning the fairness to
shareholders of a possible business combination with Unilever noted that National Starch management “feels that
some synergy may exist with the Unilever organization given a) the nature of the Unilever chemical, paper, plastics
and packaging operations … and b) the strong consumer products orientation of Unilever United States, Inc.” Id., at
77-78.
In addition to these anticipated resource-related benefits, National Starch obtained benefits through its
transformation from a publicly held, freestanding corporation into a wholly owned subsidiary of Unilever. The Court of
Appeals noted that National Starch management viewed the transaction as “swapping approximately 3500
shareholders for one.” 918 F.2d, at 427; see also App. 223. Following Unilever’s acquisition of National Starch’s
outstanding shares, National Starch was no longer subject to what even it terms the “substantial” shareholderrelations expenses a publicly traded corporation incurs, including reporting and disclosure obligations, proxy battles,
and derivative suits. Brief for Petitioner 24. The acquisition also allowed National Starch, in the interests of
administrative convenience and simplicity, to eliminate previously authorized but unissued shares of preferred and to
reduce the total number of authorized shares of common from 8,000,000 to 1,000. See 93 T.C., at 74.
Courts long have recognized that expenses such as these, ” ‘incurred for the purpose of changing the corporate
structure for the benefit of future operations are not ordinary and necessary business expenses.’ ” General
Bancshares Corp. v. Commissioner, 326 F.2d, [pg. 92-699] at 715 (quoting Farmers Union Corp. v. Commissioner,
300 F.2d 197, 200 [ 9 AFTR2d 1015] (CA9), cert. denied, 371 U.S. 861 (1962)). See also B. Bittker & J. Eustice,
Federal Income Taxation of Corporations and Shareholders, pp. 5-33 to 5-36 (5th ed. 1987) (describing “wellestablished rule” that expenses incurred in reorganizing or restructuring corporate entity are not deductible under
section 162(a)). Deductions for professional expenses thus have been disallowed in a wide variety of cases
concerning changes in corporate structure. 7 Although support for these decisions can be found in the specific terms
of §162(a), which require that deductible expenses be “ordinary and necessary” and incurred “in carrying on any
trade or business,” 8 courts more frequently have characterized an expenditure as capital in nature because “the
purpose for which the expenditure is made has to do with the corporation’s operations and betterment, sometimes
with a continuing capital asset, for the duration of its existence or for the indefinite future or for a time somewhat
longer than the current taxable year.” General Bancshares Corp. v. Commissioner, 326 F.2d, at 715. See also Mills
Estate, Inc. v. Commissioner, 206 F.2d 244, 246 [ 44 AFTR 266] (CA2 1953). The rationale behind these
decisions applies equally to the professional charges at issue in this case.
IV
The expenses that National Starch incurred in Unilever’s friendly takeover do not qualify for deduction as “ordinary
and necessary” business expenses under §162(a). The fact that the expenditures do not create or enhance a
separate and distinct additional asset is not controlling; the acquisition- related expenses bear the indicia of capital
expenditures and are to be treated as such.
The judgment of the Court of Appeals is affirmed.
It is so ordered.
1
Unilever is a holding company. Its then principal subsidiaries were Lever Brothers Co. and Thomas J. Lipton, Inc.
2
Approximately 21% of National Starch common was exchanged for Holding preferred. The remaining 79% was
exchanged for cash. App. 14.
3
Compare the Third Circuit’s opinion, 918 F.2d, at 430, with NCNB Corp. v. United States, 684 F.2d 285, 293-294
[ 50 AFTR2d 82-5281] (CA4 1982) (bank expenditures for expansion-related planning reports, feasibility studies,
and regulatory applications did not “create or enhance separate and identifiable assets,” and therefore were ordinary
and necessary expenses under §162(a)), and Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775, 782 [ 31
AFTR2d 73-935] (CA2 1973) (suggesting that Lincoln Savings “brought about a radical shift in emphasis,” making
capitalization dependent on whether the expenditure creates or enhances a separate and distinct additional asset).
See also Central Texas Savings & Loan Assn. v. United States, 731 F.2d 1181, 1184 [ 53 AFTR2d 84- 1474] (CA5
1984) (inquiring whether establishment of new branches “creates a separate and distinct additional asset” so that
capitalization is the proper tax treatment).
4
See also Johnson, The Expenditures Incurred by the Target Corporation in an Acquisitive Reorganization are
Dividends to the Shareholders, Tax Notes 463, 478 (1991) (noting the importance of a “strong law of capitalization”
to the tax system).
5
See, e.g., Commissioner v. Idaho Power Co., 418 U.S. 1 [ 34 AFTR2d 74-5244] (1974) (equipment
depreciation allocable to construction of capital facilities is to be capitalized); United States v. Mississippi Chemical
Corp., 405 U.S. 298 [ 29 AFTR2d 72-671] (1972) (cooperatives’ required purchases of stock in Bank for
Cooperative are not currently deductible); Commissioner v. Lincoln Savings & Loan Assn, 403 U.S. 345 [ 27
AFTR2d 71-1542] (1971) (additional premiums paid by bank to federal insurers are capital expenditures); Woodward
v. Commissioner, 397 U.S. 572 [ 25 AFTR2d 70-964] (1970) (legal, accounting, and appraisal expenses
incurred in purchasing minority stock interest are capital expenditures); United States v. Hilton Hotels Corp., 397
U.S. 580 [ 25 AFTR2d 70-967] (1970) (consulting, legal, and other professional fees incurred by acquiring firm in
minority stock appraisal proceeding are capital expenditures); Commissioner v. Tellier, 383 U.S. 687 [ 17
AFTR2d 633] (1966) (legal expenses incurred in defending against securities fraud charges are deductible under
section 162(a)); Commissioner v. Heininger, 320 U.S. 467 [ 31 AFTR 783] (1943) (legal expenses incurred in
disputing adverse postal designation are deductible as ordinary and necessary expenses); Interstate Transit Lines v.
Commissioner, 319 U.S. 590 [ 30 AFTR 1310] (1943) (payment by parent company to cover subsidiary’s
operating deficit is not deductible as a business expense); Deputy v. Du Pont, 308 U.S. 488 [ 23 AFTR 808]
(1940) (expenses incurred by shareholder in helping executives of company acquire stock are not deductible);
Helvering v. Winmill, 305 U.S. 79 [ 21 AFTR 962] (1938) (brokerage commissions are capital expenditures);
Welch v. Helvering, 290 U.S. 111 [ 12 AFTR 1456] (1933) (payments of former employer’s debts are capital
expenditures).
6
Petitioner contends that, absent a separate-and-distinct-asset requirement for capitalization, a taxpayer will have
no “principled basis” upon which to differentiate business expenses from capital expenditures. Brief for Petitioner 37-
41. We note, however, that grounding tax status on the existence of an asset would be unlikely to produce the
bright-line rule that petitioner desires, given that the notion of an “asset” is itself flexible and amorphous. See
Johnson, Tax Notes, at 477-478.
7
See, e.g., McCrory Corp. v. United States, 651 F.2d 828 [ 48 AFTR2d 81-5319] (CA2 1981) (statutory
merger under 26 U.S.C. §368(a)(1)(A)); Bilar Tool & Die Corp. v. Commissioner, 530 F.2d 708 [ 37 AFTR2d
76-850] (CA6 1976) (division of corporation into two parts); E.I. du Pont de Nemours & Co. v. United States,
432 F.2d 1052 [ 26 AFTR2d 70-5636] (CA3 1970) (creation of new subsidiary to hold assets of prior joint
venture); General Bancshares Corp. v. Commissioner, 326 F.2d 712, 715 [ 13 AFTR2d 649] (CA8) (stock
dividends), cert. denied, 379 U.S. 832 (1964); Mills Estate, Inc. v. Commissioner, 206 F.2d 244 [ 44 AFTR
266] (CA2 1953) (recapitalization).
8
See, e.g., Motion Picture Capital Corp. v. Commissioner, 80 F.2d 872, 873-874 [ 17 AFTR 138] (CA2 1936)
(recognizing that expenses may be “ordinary and necessary” to corporate merger, and that mergers may be “ordinary
and necessary business occurrences,” but declining to find that merger is part of “ordinary and necessary business
activities,” and concluding that expenses are therefore not deductible); Greenstein, The Deductibility of Takeover
Costs After National Starch, 69 Taxes 48, 49 (1991) (expenses incurred to facilitate transfer of business ownership
do not satisfy the “carrying on [a] trade or business” requirement of §162(a)).
© 2010 Thomson Reuters/RIA. All rights reserved.
Checkpoint Contents
Federal Library
Federal Source Materials
Federal Tax Decisions
Tax Court Reported Decisions
Tax Court & Board of Tax Appeals Reported Decisions (Prior Years)
2001
TCR Vol. 117
Illinois Tool Works Inc. et al., 117 TC 39, Code Sec(s) 162; 263, 07/31/2001
Tax Court & Board of Tax Appeals Reported Decisions
Illinois Tool Works Inc. et al. v. Commissioner, 117 TC 39, Code Sec(s) 162;
263.
ILLINOIS TOOL WORKS, INC. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent.
Case Information:
HEADNOTE
1. Business deductions—capital expenses vs. ordinary business expenses— assumed liabilities. Corp.’s
payment of assumed patent infringement judgment liabilities wasn’t currently deductible business expense: binding
precedent dictated that payment of obligation expressly assumed as part of acquisition agreement was capital
expense that became part of acquired property’s cost basis, regardless of payment’s tax character to prior owner
and irrespective of its contingent nature; and taxpayer’s reliance on distinguishable case law was rejected.
Reference(s): ¶ 1625.112(5) ; ¶ 2635.14(70) Code Sec. 162 ; Code Sec. 263
Syllabus
Official Tax Court Syllabus
P acquired the assets of D and assumed certain liabilities, including the contingent liability for a patent
infringement claim. P was subsequently held liable for damages, interest, and court costs.
HELD: P’s payment in satisfaction of the patent infringement liability is a cost of acquiring the assets of
D and must be capitalized in the year incurred.
Counsel
James P. Fuller, Jennifer L. Fuller, Laura K. Zeigler, William F. Colgin, Jr., and Kenneth B. Clark, for petitioner.
Rogelio A. Villageliu, for respondent. [pg. 40]
COHEN, Judge
Respondent determined deficiencies of $2,370,750 and $818,812, respectively, in petitioner’s consolidated Federal
income tax for 1992 and 1993.
[pg. 39]
117 T.C. No. 4
Code Sec(s): 162; 263
Docket: Dkt. No. 16022-99.
Date Issued: 07/31/2001 .
Judge: Opinion by Cohen, J.
Tax Year(s): Years 1992, 1993.
Disposition: Decision for Commissioner.
After concessions, the issue for decision is whether $6,956,590 of a payment made by petitioner in satisfaction of a
court judgment, based on a patent infringement claim that was brought against the acquired corporation and
assumed as a contingent liability by petitioner, should be capitalized as a cost of acquisition or deducted as a
business expense. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for
the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference.
Illinois Tool Works, Inc. (petitioner) is a corporation organized and existing under the laws of the State of Delaware.
At the time of the filing of the petition, petitioner’s principal place of business was located in Glenview, Illinois.
During 1992, petitioner and its subsidiaries filed a consolidated Federal income tax return, reported income on a
calendar year basis, and used the accrual method of accounting.
In 1975, the DeVilbiss Co. (DeVilbiss) was a division of Champion Spark Plug Co. (Champion). On October 9, 1975,
Jerome H. Lemelson (Lemelson), an inventor and engineer, sent a letter to DeVilbiss offering to license certain
patents, including a patent called the ““431 patent”. In 1978, DeVilbiss secured a license, from the Trallfa Co. of
Norway (Trallfa), to sell Trallfa robots in North America. Trallfa robots are computer-controlled hydraulically actuated
paint spray devices that are designed to mimic human arm and wrist motions during painting operations. On
September 17, 1979, attorneys for Lemelson sent a letter to DeVilbiss asserting that DeVilbiss was producing certain
products in the industrial robot and manipulator field that might be infringing certain Lemelson patents including the
‘431 patent. On behalf of DeVilbiss, the director of robotic operations at DeVilbiss wrote a reply letter to Lemelson’s
attorneys that denied any infringement. On May 23, 1980, DeVilbiss and [pg. 41] Trallfa entered into a new license
agreement that gave DeVilbiss the right to manufacture, as well as to sell, Trallfa robots.
In 1981, Lemelson filed a lawsuit against the United States of America in the U.S. Court of Claims (Court of Claims
lawsuit) alleging patent infringement for the Federal Government’s purchase and use of certain robots including the
Trallfa robot. Champion, as owner of DeVilbiss, entered the case as a third-party defendant. During one court
session, the presiding judge stated that, after reviewing the merits, he did not believe that Lemelson was likely to
succeed on his patent infringement claim. The parties to the Court of Claims lawsuit ultimately reached a settlement
that required the Federal Government to pay $5,000 to Lemelson. The Federal Government sought indemnification
from Champion.
On May 13, 1985, Lemelson filed a separate lawsuit against Champion directly, as owner of DeVilbiss, in the U.S.
District Court for the District of Delaware (the Lemelson lawsuit). In his petition, Lemelson alleged that the
manufacture and sale of the Trallfa robot infringed several of his patents, including the ‘431 patent. The Lemelson
lawsuit sought damages for Trallfa robots that were sold prior to 1986. On August 16, 1989, Lemelson made an offer
to settle the lawsuit for $500,000, which DeVilbiss rejected.
DeVilbiss retained Mark Curran Schaffer (Schaffer), an intellectual property attorney, to represent DeVilbiss in the
Lemelson lawsuit. Schaffer reviewed the patents, studied the patent file histories, performed prior art searches, and
compared Lemelson’s patents with the Trallfa robot. Schaffer concluded that Lemelson’s patents were not infringed
by the Trallfa robot and that it was unlikely that Lemelson would succeed in proving infringement. Schaffer
communicated his opinion to representatives of DeVilbiss.
Larry Becker (Becker), division counsel and secretary of DeVilbiss at the time that the Lemelson lawsuit was filed,
also reviewed the Lemelson lawsuit. Although Becker believed that the Lemelson lawsuit was not worth anything, he
and his staff determined that the range of exposure would be between $25,000 and $500,000.
Prior to 1990, Eagle Industries, Inc. (Eagle), a company unrelated to petitioner, purchased DeVilbiss from Champion
[pg. 42] and subsequently incorporated DeVilbiss under the laws of the State of Delaware as a wholly owned
subsidiary of Eagle. In 1990, petitioner entered into a purchase agreement to acquire certain assets relating to the
industrial and commercial business operations of DeVilbiss. Petitioner agreed to pay $126.5 million for the assets and
an additional $12.5 million for a covenant not to compete. The purchase agreement specified that, at closing, the
buyer assumed certain liabilities of the seller and, in part, states:
At the Closing, Buyer shall assume:
(a) the Liabilities associated with the Companies whose Stock is being purchased hereunder;
(b) the Liabilities to the extent of the amounts actually reserved for or that are specifically noted on the
February 2, 1990 Balance Sheet and the supporting documentation thereto ***
(c) those Liabilities to the extent specifically provided for in this Agreement or to the extent disclosed on
the Schedules or Exhibits to this Agreement;
Closing was to occur after petitioner completed a due diligence review and other specified events. The purchase
agreement disclosed that DeVilbiss had created a $400,000 reserve for pending patent liability claims and legal fees
expected to be incurred in litigating the Lemelson lawsuit. After the price was set for the acquisition and during the
due diligence period, DeVilbiss made disclosure to petitioner of pending lawsuits, including the Lemelson lawsuit.
DeVilbiss provided to petitioner a schedule containing the following entry:
CDCA STATE DATE CLAIM AMT
Lemelson, Jerome v. Champion DE 06/19/85 Open
ACTION Patent infringement claim — Robot Apparatus
COMMENTS Latest settlement demand is $500,000. Further
discovery and trial pending.
During the due diligence period, Becker expressed his opinion to representatives of petitioner that he did not believe
that the Lemelson lawsuit was worth anything. Although Champion remained the named defendant in the Lemelson
lawsuit, petitioner became the party in interest after petitioner acquired the assets of DeVilbiss.
During the due diligence period, representatives of petitioner, including Gary F. Anton (Anton), petitioner’s director
[pg. 43] of audits; Thomas Buckman (Buckman), petitioner’s vice president of patents and technology; and John
Patrick O’Brien (O’Brien), petitioner’s group technology counsel, also studied the patents and formed the conclusion
that the Lemelson lawsuit would most likely result in no liability exposure. Anton was the lead on-site due diligence
person for petitioner’s acquisition of the DeVilbiss assets, and Buckman and O’Brien were attorneys and members of
the patent bar. The representatives of petitioner estimated that legal fees of approximately $400,000 would be
incurred to defend the lawsuit. The “worst case scenario” that was contemplated by petitioner’s representatives
was that petitioner could incur a liability of between $1 million and $3 million. However, they concluded that the
likelihood of this exposure was somewhere between zero and 5 percent. They believed that there was a 98- to 99-
percent chance that petitioner would prevail in the patent infringement claim.
The reserve for the Lemelson lawsuit, in the course of the acquisition, was eventually set at $350,000. At the
conclusion of the due diligence review, the purchase price of the DeVilbiss assets was adjusted from $126.5 million
to $125.5 million. Petitioner and DeVilbiss considered the pending Lemelson lawsuit, but the lawsuit liability did not
affect the adjustment in the purchase price. The acquisition closed on April 24, 1990.
After the acquisition, petitioner assumed the defense of the Lemelson lawsuit in the District Court in 1991. On
January 17, 1991, the jury returned a verdict against Champion (and, thus, against petitioner as the party in
interest), finding that Champion had willfully infringed the ‘431 patent that was owned by Lemelson. The jury
awarded damages of $4,647,905 for patent infringement and $6,295,167 for prejudgment interest. The District Court
doubled the $4,647,905 damage award for patent infringement due to the jury’s finding of willful infringement. The
finding of willfulness was based in part on the failure of Champion (and on the failure of petitioner as the party in
interest) to secure an authoritative opinion on whether the Trallfa robot violated the ‘431 patent until 2 months
before trial.
Petitioner appealed the judgment of the District Court to the U.S. Court of Appeals for the Federal Circuit. On July
13, 1992, the Court of Appeals affirmed without published [pg. 44] opinion the decision of the District Court,
Lemelson v. Champion Spark Plug Co., 975 F.2d 869 (Fed. Cir. 1992). In 1992, after all appeals were exhausted,
petitioner paid the judgment, including accumulated interest, of $17,067,339. The $17,067,339 judgment included
the damages and prejudgment interest totaling $15,590,977 that were awarded by the District Court, postjudgment
interest of $1,470,389.92, and court costs of $5,971.74.
OPINION
The portion of the $17,067,339 court judgment that is in issue is $6,956,590 because: (1) Petitioner capitalized $1
million in its tax return, (2) respondent conceded an allowance of $2,154,160 for postacquisition interest expense,
and (3) respondent conceded a reduction of $6,956,589 for the disposal of acquisition assets. We must decide
whether the $6,956,590 in dispute should be capitalized as a cost of acquisition or deducted as a business expense.
Section 162(a) provides a deduction for a taxpayer when an expenditure is: (1) An expense, (2) an ordinary
expense, (3) a necessary expense, (4) incurred during the taxable year, and (5) made to carry on a trade or
business. Commissioner v. Lincoln Sav. & Loan Association, 403 U.S. 345, 352-353 [27 AFTR 2d 71-1542] (1971).
An expenditure is a “necessary expense” when it is appropriate or helpful to the development of a taxpayer’s
business. Commissioner v. Tellier, 383 U.S. 687, 689 [17 AFTR 2d 633] (1966). An expenditure is an “ordinary
expense” when it is “normal, usual, or customary” in the type of business involved. Deputy v. Du Pont, 308 U.S.
488, 495-496 [23 AFTR 808] (1940). Petitioner bears the burden of proving entitlement to the claimed deduction.
Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 [69 AFTR 2d 92-694] (1992).
No current deduction is allowed for a capital expenditure. See sec. 263(a)(1). Section 1.263(a)-2(a), Income
Tax Regs., includes as examples of capital expenditures “The COST OF ACQUISITION *** of buildings, machinery
and equipment, furniture and fixtures, and similar property having a useful life substantially beyond the taxable
year.” (Emphasis added.) Generally, the payment of a liability of a preceding owner of property by the person
acquiring such property, whether or not such liability was fixed or contingent at the [pg. 45] time such property was
acquired, is not an ordinary and necessary business expense. David R. Webb Co. v. Commissioner, 708 F.2d
1254, 1257 [52 AFTR 2d 83-5104] (7th Cir. 1983), affg. 77 T.C. 1134 (1981); Pac. Transp. Co. v. Commissioner,
483 F.2d 209 [32 AFTR 2d 73- 5663] (9th Cir. 1973), vacating and remanding T.C. Memo. 1970-41 [¶70,041
PH Memo TC]; United States v. Smith, 418 F.2d 589, 596 [24 AFTR 2d 69-5599] (5th Cir. 1969); M. Buten &
Sons, Inc. v. Commissioner, T.C. Memo. 1972-44 [¶72,044 PH Memo TC]. Instead, payment of such a liability is
capitalized and added to the basis of the acquired property.
Petitioner contends that the amount of the payment that was made in satisfaction of the Lemelson lawsuit should
not be added to the cost basis of the property that was acquired in the asset acquisition from DeVilbiss because the
payment was highly speculative and unexpected at the time of purchase. Petitioner relies on the Tax Court’s
decision in Pac. Transp. Co. v. Commissioner, T.C. Memo. 1970-41 [¶70,041 PH Memo TC], vacated and
remanded 483 F.2d 209 [32 AFTR 2d 73- 5663] (9th Cir. 1973). Petitioner’s alternative arguments are: (1) A
payment in satisfaction of an assumed liability, which would have been a deductible expense if it had been paid by
DeVilbiss, the acquired corporation, retains its deductible character when petitioner, the acquiring corporation,
becomes the party in interest and (2) as a result of petitioner’s efforts in defending the Lemelson lawsuit, the final
judgment amount that petitioner paid was an ordinary and necessary business expense that was directly connected
to the business operations. In support of these alternative arguments, petitioner relies on Nahey v. Commissioner,
196 F.3d 866 [84 AFTR 2d 99- 7008] (7th Cir. 1999), affg. 111 T.C. 256 (1998).
Respondent maintains that the assets that petitioner received in exchange for the sales price, which included the
assumed liabilities, produced a substantial benefit to petitioner in future years as the assets were used in petitioner’s
business. Respondent maintains that the Lemelson lawsuit was a contingent liability of DeVilbiss that was assumed,
in full, by petitioner as consideration for the acquired assets of DeVilbiss. Therefore, respondent contends,
regardless of whether the final amount of the liability was unexpected or remote at the time of acquisition, the total
sum of the payment for the assumed contingent liability must be added to the cost basis of the property that was
acquired in the asset acquisition. Respondent relies on the Court of Appeals for the [pg. 46] Ninth Circuit’s decision
in Pac. Transp. Co. v. Commissioner, 483 F.2d 209 [32 AFTR 2d 73-5663] (9th Cir. 1973), vacating and
remanding T.C. Memo. 1970-41 [¶70,041 PH Memo TC].
Respondent also relies on David R. Webb Co. v. Commissioner, 77 T.C. 1134 (1981), affd. 708 F.2d 1254 [52
AFTR 2d 83-5104] (7th Cir. 1983), in which a taxpayer expressly assumed the obligation to make pension payments
to the widow of a corporate officer for her life as part of the purchase of the assets and liabilities of a corporation.
Prior to the acquisition of the corporation by the taxpayer, the corporation made the pension payments and
deducted the payments as ordinary and necessary business expenses. Upon acquisition, the taxpayer continued to
make the pension payments to the widow and claimed a deduction for the amount of the pension payments. This
Court stated:
It is well settled that the payment of an obligation of a preceding owner of property by the person
acquiring such property, whether or not such obligation was fixed, contingent, or even known at the
time such property was acquired, is not an ordinary and necessary business expense. Rather, when paid,
such payment is a capital expenditure which becomes part of the cost basis of the acquired property.
Such is the result irrespective of what would have been the tax character of the payment to the prior
owner. United States v. Smith, 418 F.2d 589, 596 [24 AFTR 2d 69-5599] (5th Cir. 1969);
Portland Gasoline Co. v. Commissioner, 181 F.2d 538, 541 [39 AFTR 408] (5th Cir. 1950), affg. on this
issue a Memorandum Opinion of this Court; [1949 PH TC Memo ¶49,108] W.D. Haden Co. v.
Commissioner, 165 F.2d 588, 591 [36 AFTR 670] (5th Cir. 1948). affg. on this issue a
Memorandum Opinion of this Court; [1946 PH TC Memo ¶ 46,089] Holdcroft Transportation Co. v.
Commissioner, 153 F.2d 323 [34 AFTR 860] (8th Cir. 1946), affg. a Memorandum Opinion of this
Court; [1945 PH TC Memo ¶45,167] *** [Id. at 1137-1138.]
On appeal, the Court of Appeals for the Seventh Circuit dismissed the taxpayer’s argument that a contingent liability
that was insusceptible of present valuation at the time of the acquisition could not be capitalized as a cost of
acquisition. The Court of Appeals held that, when the actual amount of the contingent liability is known, the amount
can be added to the cost basis of the purchased property. David R. Webb Co. v. Commissioner, 708 F.2d 1254,
1258 [52 AFTR 2d 83-5104] (7th Cir. 1983), affg. 77 T.C. 1134 (1981).
We conclude that David R. Webb Co., not Nahey v. Commissioner, supra, is applicable to the facts in this case. In
Nahey, the issue was whether proceeds of litigation prosecuted to judgment were taxed as capital gains or ordinary
income. The Court of Appeals held that the proceeds were [pg. 47] ordinary income to the buyer of the corporation
that had initially held the legal claim for lost corporate income. In that context, the Court noted that the character
of income did not change as a result of the acquisition, stating that “what was transferred as part of a corporate
acquisition was an asset that yields ordinary income”. Nahey v. Commissioner, supra at 869. We are not persuaded
by petitioner’s attempt to extend this rationale to the present case in contravention of the consistently applied rule
that payment of liabilities assumed as part of an acquisition must be capitalized.
Because we believe that David R. Webb Co. is the controlling authority in this case, we need not decide the dispute
between the parties over the status of Pac. Transp. Co. v. Commissioner, supra. We note, however, that the Court
of Appeals, in reversing our decision, relied on two Supreme Court cases, Woodward v. Commissioner, 397 U.S.
572 [25 AFTR 2d 70-964] (1970), and United States v. Hilton Hotels, 397 U.S. 580 [25 AFTR 2d 70-967] (1970),
decided after our Memorandum Opinion was released.
In settling on a final price for the DeVilbiss industrial and commercial assets, the possibility of incurring a liability on
the patent infringement claim in the Lemelson lawsuit was considered by both petitioner and DeVilbiss. DeVilbiss, as
seller, disclosed the patent infringement claim that arose from its activities to petitioner during the due diligence
period. Petitioner, as buyer, was aware of the Lemelson lawsuit and expressly assumed the contingent liability as
part of the acquisition agreement. Both petitioner and DeVilbiss contemplated the possible exposure that might result
from the Lemelson lawsuit and sought the opinion of their corporate officers. Although the liability did not affect the
negotiations or the final established purchase price, the assumed liability of the Lemelson lawsuit transferred to
petitioner pursuant to the purchase agreement.
The Lemelson lawsuit, like the contingent liability in David R. Webb Co. v. Commissioner, supra, was a contingent
liability that petitioner was aware of prior to the acquisition of assets and liabilities from DeVilbiss and that petitioner
expressly assumed in the purchase agreement. Additionally, the status of the Lemelson lawsuit was considered in
determining the final purchase price, and petitioner created a reserve for the liability arising from the patent
infringement claim. [pg. 48]
Following David R. Webb Co., we conclude that petitioner’s payment of the court judgment, which was an obligation
of DeVilbiss and acquired by petitioner, whether or not such obligation was fixed, contingent, or even known at the
time such property was acquired, was not an ordinary and necessary business expense. Such payment is a capital
expenditure that becomes part of the cost basis of the acquired property regardless of what would have been the
tax character of the payment to the prior owner. See David R. Webb Co. v. Commissioner, 77 T.C. at 1137-1138;
see also Meredith Corp. & Subs. v. Commissioner, 102 T.C. 406, 454-455 (1994) (holding that the time at which
a contingent liability that is assumed in an asset acquisition is to be capitalized occurs when the expense is
incurred).
We have considered all of the remaining arguments that have been made by the parties for a result contrary to that
expressed herein, and, to the extent not discussed above, they are irrelevant or without merit.
To reflect the foregoing and the concessions of the parties,
Decision will be entered under Rule 155.
© 2010 Thomson Reuters/RIA. All rights reserved.
Checkpoint Contents
Federal Library
Federal Source Materials
Federal Tax Decisions
American Federal Tax Reports
American Federal Tax Reports (Prior Years)
2004
AFTR 2d Vol. 93
93 AFTR 2d 2004-566 (355 F.3d 1179) – 93 AFTR 2d 2004-439 (85 Fed. Appx. 333)
ILLINOIS TOOL WORKS INC. & SUBSIDIARIES v. COMM., 93 AFTR 2d 2004-548 (355 F.3d 997), Code
Sec(s) 162; 263, (CA7), 01/21/2004
American Federal Tax Reports
ILLINOIS TOOL WORKS INC. & SUBSIDIARIES v. COMM., Cite as 93 AFTR 2d
2004-548 (355 F.3d 997), 01/21/2004 , Code Sec(s) 162; 263
ILLINOIS TOOL WORKS INC. AND SUBSIDIARIES, PETITIONER-APPELLANT v. COMMISSIONER of Internal Revenue,
RESPONDENT-APPELLEE.
Case Information:
HEADNOTE
1. Business deductions—capital expenses vs. ordinary business expenses—assumed liabilities. Tax Court
properly held that corp.’s payment of assumed patent infringement judgment liabilities was capitalizable cost of
acquiring prior owner’s property, not deductible business expense: case precedent was properly interpreted as
generally requiring capitalization of payment of prior owner’s liability, regardless of its contingent nature; taxpayer
knowingly assumed contingent liability as part of purchase agreement for prior owner; and parties’ expectation of
liabilities’ ultimate value and taxpayer’s alleged ability, post-acquisition, to negatively impact liability amount were
irrelevant. Also, liabilities were nondeductible where “incurred for the purpose of changing the corporate structure
for the benefit of future operations”; and taxpayer’s failure to settle patent suit post-acquisition was irrelevant as to
its ultimate valuation where suit was mishandled from its outset.
Reference(s): ¶ 1625.112(5) ; ¶ 2635.14(70) Code Sec. 162 ; Code Sec. 263
OPINION
In the United States Court of Appeals For the Seventh Circuit,
Appeal from the United States Tax Court. No. 16022-99—Mary Ann Cohen, Judge.
Before Bauer, Kanne, and Evans, Circuit Judges.
Judge: Kanne, Circuit Judge.
Illinois Tool Works Inc. and its subsidiaries (“ITW”) appeal from the tax court’s determination that $6,956,590 of a
more than $17 million court judgment paid by ITW should be capitalized as a cost of acquiring certain assets of the
DeVilbiss Co. rather than deducted as an ordinary business expense. The judgment at issue was [pg. 2004-549] the
Code Sec(s): 162; 263
Court Name: U.S. Court of Appeals, Seventh Circuit,
Docket No.: No. 02-1239,
Date Decided: 01/21/2004.
Prior History: Tax Court, (2001) 117 TC 39 (opinion by Cohen, J. ), affirmed.
Tax Year(s): Years 1992, 1993.
Disposition: Decision against Taxpayer.
Cites: 355 F.3d 997 , .
result of a jury verdict in a patent infringement suit filed against DeVilbiss’s former owner, Champion Spark Plug, Inc.
ITW assumed the pending lawsuit, and its defense, upon its acquisition of DeVilbiss in 1990. ITW acknowledges that
at least a portion of the judgment should be capitalized as a cost of acquisition, but disputes the amount. We agree
with the determination of the tax court and affirm.
I. History
The facts are not in dispute. DeVilbiss was a division of Champion in the 1970s. In 1975, Jerome H. Lemelson, an
inventor and engineer, wrote DeVilbiss and offered to license it certain of his patents, including the “’431 patent.”
DeVilbiss, fatefully, did not take Lemelson up on the offer.
Instead, in 1978, DeVilbiss acquired a license from a Norwegian company named Trallfa to sell its computercontrolled paint-spray robots. Attorneys for Lemelson contacted DeVilbiss in 1979, notifying it that certain of its
products in the robot and manipulator field might be infringing on Lemelson’s patents, including the §431 patent.
DeVilbiss’s director of robotic operations replied, summarily denying any infringement. Thereafter, in 1980, DeVilbiss
and Trallfa entered a new license agreement whereby DeVilbiss gained the right to manufacture, as well as to sell,
Trallfa robots.
The first of two relevant patent infringement suits brought by Lemelson followed in 1981. Lemelson launched that
suit in the U.S. Court of Claims (“Court of Claims lawsuit”) against the United States, alleging that its purchase and
use of certain robots, including the Trallfa robot, infringed his patents. Champion, owner of DeVilbiss, entered as a
third-party defendant. The government ultimately settled that suit for $5000 and sought indemnification from
Champion. Notably, the presiding judge in that action told the parties prior to settlement that based on his view of
the merits, Lemelson was unlikely to succeed.
Lemelson filed the second patent infringement suit in 1985 against Champion directly (“Lemelson lawsuit”), alleging
as he had before that the Trallfa robot infringed on several of his patents, including the §431 patent. He sought
damages relating to the sale of Trallfa robots prior to 1986. That case was stayed shortly after filing, pending the
resolution of the 1981 Court of Claims lawsuit.
DeVilbiss retained counsel to represent it in the Lemelson lawsuit. That attorney, Mark C. Schaffer, specialized in
intellectual property law. In his estimation the case was meritless, and he communicated the same to DeVilbiss.
Larry Becker, division counsel and secretary of DeVilbiss at the time the Lemelson lawsuit was filed, also evaluated
the case and came to the same conclusion. But, he set a range of exposure between $25,000 and $500,000 for
internal purposes. In 1989, before ITW purchased DeVilbiss, Lemelson offered to settle for $500,000. DeVilbiss
rejected the offer, countering with $25,000. Although not clear from the record, settlement discussions apparently
stalled, and, in any event, no settlement was reached at that time.
ITW acquired DeVilbiss in 1990. 1 In the purchase agreement, ITW agreed to assume certain liabilities of the seller,
which included the pending Lemelson lawsuit. ITW became aware of the Lemelson lawsuit prior to closing, during the
due diligence phase of the sale, which ITW conducted over a ten-to-fourteen-day period. As part of the due
diligence review, DeVilbiss disclosed all of its pending litigation, including the Lemelson lawsuit. Although the damages
claimed by Lemelson were described as “open” on the schedule provided to ITW, Becker reiterated his opinion that
the lawsuit was meritless. ITW representatives, including its director of audits, vice president of patents and
technology, and group technology counsel (the latter two patent attorneys), reviewed the Lemelson case and
agreed with Becker. They ascribed a 98-to-99 percent chance of [pg. 2004-550] prevailing at trial, with a worst
case scenario exposure of $1 million to $3 million. They also negotiated a $350,000 cash reserve to cover the
attorneys’ fees expected to be incurred in defending the suit. Except for the accountants, Arthur Andersen, and
Schaffer, the outside counsel retained by DeVilbiss, the record reveals no other outside analysts brought in to
examine the risk represented by the Lemelson lawsuit.
As a result of ITW’s due diligence findings, the agreed purchase price for DeVilbiss was lowered from $126.5 million to
$125.5 million. The Lemelson lawsuit was not a factor in this decision.
After the deal closed, the Lemelson lawsuit was reopened, and ITW assumed the defense as the real party in
interest, although Champion remained named in the caption. ITW continued to employ Schaffer, the outside counsel
initially hired by DeVilbiss, to represent it. At various points prior to and during trial, Lemelson offered to settle the
case. The last offer, for more than $1 million, came after most of the evidence had been heard and at the urging of
the trial court. ITW rejected the settlement offer and did not counter.
In January 1991, a jury returned a verdict in favor of Lemelson. It awarded $4,647,905 for patent infringement and
$6,295,167 in prejudgment interest. The district court doubled the patent infringement award because the jury
found that not only had the §431 patent been infringed, it had been willfully infringed. The willfulness finding was
based in part on Champion’s failure to secure an authoritative opinion on whether the Trallfa robot infringed the §431
patent until two months before trial. ITW was, to say the least, stunned by the $15,590,977 verdict.
ITW appealed and lost. It finally paid the judgment in 1992, which, with accumulated interest, totaled $17,067,339.
On its 1992 tax return, it capitalized $1 million of the judgment as a cost of acquiring DeVilbiss and deducted the
remaining $16 million as an ordinary business expense. The reason for the bifurcation, as explained in ITW’s Form
8275-R Disclosure Statement that accompanied its 1992 return, was that since it could have settled the Lemelson
lawsuit for $1 million, the remaining $16 million liability resulted from the post-acquisition business decision to reject
the settlement offer and chance it in court. In essence, ITW contended that its gamble on a jury trial caused it to
incur significant additional expenditures over $1 million (the perceived worth of the lawsuit based on the last
settlement offer)—not the acquisition of DeVilbiss and its contingent liability in the form of the Lemelson suit. As
such, ITW reasoned that the amount of the judgment attributable to its bad decisions should be deducted as an
ordinary business expense rather than capitalized as a cost of acquisition. The Commissioner of Internal Revenue and
the tax court rejected this novel mea culpa argument and so do we. 2
II. Analysis
[1] This case revolves around the difference between capital and ordinary business expenses as expressed in the
Internal Revenue Code. The Code allows the immediate deduction of “all ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or business.” 16 U.S.C. § 162(a); INDOPCO v.
Commissioner, 503 U.S. 79, 83 [69 AFTR 2d 92-694] (1992). The opposite is true of capital expenses, which the
Code defines as “an amount paid out for new buildings or for permanent improvements or betterments made to
increase the value of any property or estate.” 26 U.S.C. § 263(a)(1); INDOPCO, 503 U.S. at 83. Ordinary
business expenses, then, are generally incurred to meet a taxpayer’s immediate or current business needs within the
present taxable year. See id. at 85. Capital expenses are generally incurred for the taxpayer’s future benefit. Id. at
90 (noting that generally an expense is characterized as capital when “the purpose for which the expenditure is
made has to do with the corporation’s operations and betterment [pg. 2004-551] … for the duration of its existence
or for the indefinite future or for a time somewhat longer than the current taxable year.” (quotations omitted)).
The practical result of labeling an expense “ordinary” or “capital” is that generally a taxpayer can take an immediate,
full deduction for ordinary business expenses and realize an immediate corresponding reduction in taxable income,
while capital expenses generally result in smaller yearly deductions over time through amortization and depreciation.
As summarized by the Supreme Court:
The primary effect of characterizing a payment as either a business expense or a capital expenditure
concerns the timing of the taxpayer’s cost recovery: While business expenses are currently deductible, a
capital expenditure usually is amortized and depreciated over the life of the relevant asset, or, where no
specific asset or useful life can be ascertained, is deducted upon dissolution of the enterprise. See
U.S.C. §§ 167(a) and 336(a); Treas. Reg. § 1.167(a), 26 C.F.R. § 1.167(a). Through
provisions such as these, the Code endeavors to match expenses with the revenues of the taxable
period to which they are properly attributable, thereby resulting in a more accurate calculation of net
income for tax purposes.
INDOPCO, 503 U.S. at 83–84.
“Whether a taxpayer is required to capitalize particular expenses is a question of law, and our review is therefore de
novo.” U.S. Freightways Corp. v. Commissioner, 270 F.3d 1137, 1139 [88 AFTR 2d 2001- 6703] (7th Cir. 2001);
see also Wells Fargo & Co. v. Commissioner, 224 F.3d 874, 880 [86 AFTR 2d 2000-5815] (8th Cir. 2000). We
note that ITW, who argues that the majority of the Lemelson judgment should be labeled ordinary business
expenses, hence fully and immediately deductible, bears the burden of proving entitlement to the claimed deduction.
U.S. Freightways, 270 F.3d at 1145. This is because income tax deductions are a matter of legislative grace and the
exception to the norm of capitalization. Id.; INDOPCO, 503 U.S. at 84.
ITW’s burden is particularly heavy because, as recognized by the tax court, our prior precedent states that there is
a “well- settled general rule that when an obligation is assumed in connection with the purchase of capital assets,
payments satisfying the obligation are non-deductible capital expenditures.” David R. Webb Co., Inc. v.
Commissioner , 708 F.2d 1254, 1256 [52 AFTR 2d 83-5104] (7th Cir. 1983). ITW acknowledged the force of this
rule when it capitalized a portion of the Lemelson judgment as attributable to the obligation (in the form of the
pending lawsuit) assumed upon acquiring DeVilbiss.
Relying on A.E. Staley Mfg. Co. v. Commissioner, 119 F.3d 482 [80 AFTR 2d 97-5060] (7th Cir. 1997), though,
ITW argues that the tax court erred by applying the rule articulated in Webb inflexibly and eschewing the pragmatic,
“real life” inquiry advanced in Staley. Had it approached ITW’s challenge properly, ITW posits, the tax court would
have found that except for ITW’s mishandling of the lawsuit after acquisition, the value of the Lemelson lawsuit
would have been “capped” at $1 million. Thus, anything above $1 million should be attributable to decisions made in
the course of defending the litigation and deducted as an ordinary business expense. See, e.g., Commissioner v.
Tellier, 383 U.S. 687 [17 AFTR 2d 633] (1966) (legal expenses incurred in defending against securities fraud
charges deductible under § 162(a)); Commissioner v. Heininger, 320 U.S. 467 [31 AFTR 783] (1943) (legal
expenses incurred in disputing adverse postal designation deductible as ordinary and necessary business expenses).
We find fault with ITW’s argument on several levels.
A. ITW misreads the tax court’s approach to Webb.
First, the tax court did not apply Webb inflexibly. ITW reads the tax court’s opinion to state that “any payment in
satisfaction of a contingent liability acquired in a capital transaction is always a capital expenditure.” (Appellants’
Opening Br. at [pg. 2004-552] 19). We do not read the tax court’s opinion so restrictively. Rather, we note the
opinion accurately cites Webb for the proposition that “[g]enerally, the payment of a liability of a preceding owner of
property by the person acquiring such property, whether or not such liability was fixed or contingent at the time
such property was acquired, is not an ordinary and necessary business expense.” Illinois Tool Works, Inc. v.
Commissioner, 117 T.C. 39, 44–45 (2001) (emphasis added). The tax court’s language analyzing ITW’s case in
light of the above general principle does not foreclose in every circumstance an outcome different than the one
reached; rather, it simply notes that ITW’s arguments for treating all but $1 million of the judgment as an ordinary
business expense are not persuasive in “the present case.” Id. at 47. 3
B. Webb controls
Next, we agree with the tax court that the facts of this straightforward case do not dictate a departure from Webb.
In Webb, the taxpayer acquired a wood veneer company that many years ago agreed to pay an employee’s widow,
Mrs. Grunwald, a lifetime pension of $12,700 annually. 708 F.2d at 1255. The taxpayer knowingly assumed the
liability to Mrs. Grunwald as part of the purchase agreement. Id. In tax years thereafter it attempted to deduct, as
an ordinary and necessary business expense, the $12,700 paid to Mrs. Grunwald. The Commissioner determined that
the $12,700 was not an ordinary business expense, but a capital one, which the tax court upheld. Id. at 1255–56.
We affirmed, observing that because the taxpayer agreed to assume the pension payments as part of its purchase
agreement for the wood veneer business, the payments were more properly attributed to that capital investment,
not its current business operations. Id. at 1256. In essence, the agreement to pay the debt to the widow served as
part of the purchase price for the business. Id. (“Assumption of the obligation to make pension payments to Mrs.
Grunwald was in theory and in fact, part of the cost of acquiring the assets of the wood veneer business from the
taxpayer’s predecessor.”) Because the purchase of the wood veneer business was meant to enhance the taxpayer’s
operations into the future, the expenses to acquire it—which included the discharge of the annual debt to Mrs.
Grunwald—had to be capitalized. Id. (stating that generally “when an obligation is assumed in connection with the
purchase of capital assets, payments satisfying the obligation are non-deductible capital expenditures”).
Similarly, ITW knowingly assumed the Lemelson lawsuit as part of the purchase agreement for the DeVilbiss assets.
Because ITW agreed to pay that contingent liability in exchange for DeVilbiss, that contingent liability formed part of
the purchase price. Because the DeVilbiss acquisition was meant to benefit ITW into the future, the expenses to
acquire it—including the Lemelson lawsuit, once assigned a value through the judgment—must be capitalized.
ITW attempts to distinguish Webb based on the parties’ expectation of the ultimate value of the Lemelson lawsuit
and on ITW’s alleged ability, post-acquisition, to negatively impact the liability amount. In Webb, the acquiring
company knew that it owed an annual liability of $12,700 and that it would end when Mrs. Grunwald passed.
Therefore, ITW argues, the parties in Webb had a complete understanding of the scope of the contingent liability at
stake in the deal, unlike in the case before us where the parties to the transaction failed to grasp the risk
represented by the Lemelson lawsuit. ITW also urges that since the taxpayer in Webb could do nothing to affect the
amount of the liability, unlike here where the failure to accept a settlement offer increased the debt exponentially,
Webb should be ignored.
ITW’s attempts to distance itself from Webb are unavailing. ITW agreed to assume the Lemelson defense and pay
any judgment, whatever it may be. Although we have no doubt the parties earnestly be- [pg. 2004-553] lieved the
case was meritless, ITW cannot dispute that it acknowledged some risk, albeit minimal, and did not take steps to
mitigate that risk. It could have lowered the purchase price or inserted an indemnification clause in the purchase
agreement to recoup any losses not anticipated by the parties. That a contingent liability, once fixed, exceeded the
parties’ expectations does not render it any less a part of the purchase price. See Pacific Transport Co. v.
Commissioner, 483 F.2d 209, 213 [32 AFTR 2d 73-5663] (9th Cir. 1973) (noting that a taxpayer’s failure to
realize the substance or amount of a contingent liability assumed when acquiring property does not change its tax
treatment—the payment must be capitalized); but see Nahey v. Commissioner, 196 F.3d 866, 870 [84 AFTR 2d
99-7008] (7th Cir. 1999) (criticizing Pacific Transport in dicta). In this case, protection from an aberrant jury verdict
needed to be sought during contract formation, not after the fact in the form of an immediate tax deduction.
Moreover, ITW’s entire premise that its actions after assuming the liability should be examined for the effect it had
on increasing the amount of the ultimate indebtedness strays from the inescapable fact that, like the taxpayer in
Webb, it accepted the indebtedness in order to acquire what it perceived to be a future benefit—DeVilbiss. Part of
ITW’s process of valuing the DeVilbiss assets and arriving at the purchase price included evaluating the Lemelson
lawsuit. In that due diligence phase, ITW assessed a value to the suit based on how it foresaw the litigation
unfolding once it took control of the defense. Its ability to affect the outcome of the Lemelson lawsuit was therefore
already factored in. That things did not go according to plan, and that, in retrospect, it should have paid far less for
DeVilbiss to account for size of the judgment assigned, does not change the tax character of the judgment in this
case.
C. Staley’s Application
Finally, Staley does not warrant a different outcome, as ITW insists. In Staley, this Court reversed the tax court’s
determination that fees paid to investment bankers to unsuccessfully ward off a hostile takeover had to be
capitalized by the defending company, rather than deducted as an ordinary business expense. 119 F.3d at 483. The
tax court, in determining that these incidental fees were part of the capital transaction ultimately resulting in the
taxpayer’s hostile acquisition by a corporate raider, purported to follow the Supreme Court’s decision in INDOPCO v.
Commissioner, 503 U.S. 79 [69 AFTR 2d 92-694] (1992). Id. at 485. The INDOPCO case also involved investment
banking fees, but in the context of a friendly, as opposed to hostile, takeover of National Starch by Unilever. There
the Court found that the money paid to the investment bankers by National Starch was for the purpose of
facilitating a favorable merger with Unilever, thus changing the corporate structure for the benefit of future
operations—a capital expense. INDOPCO , 503 U.S. at 88–90.
In disagreeing with the tax court’s application of INDOPCO, we found it significant that the majority of the fees paid
in Staley were for the purpose of defending against what the company perceived to be an unfavorable, hostile
takeover. Staley, 119 F.3d at 491. Because defending a company against attack is considered a necessary and
ordinary business expense, designed to benefit current operations, id. at 487, we remanded the case to the tax
court. We asked it to allocate the fees paid between those activities that were considered in defense of the
company, an ordinary expense immediately deductible, and those that facilitated the ultimate merger, a capital
expense meant to benefit the company into the future. Id. at 492–493.
Our analysis in Staley was based on the recognition that distinguishing between ordinary expenses and those that
must be capitalized can sometimes be difficult. Id. at 487 (“As the Supreme Court has noted, “the cases sometimes
appear difficult to harmonize,” and “each case turns on its special facts.”” (quoting INDOPCO, 503 U.S. at 86)).
When faced with this challenge, we observed that “distinguishing between ordinary and capital costs often [pg.
2004-554] requires a rather pragmatic approach.” Id. Staley was such a case, with its factual similarities to the
INDOPCO decision and turning on incidental, rather than direct, costs of an acquisition. Therefore, we specifically
applied a “pragmatic assessment” to the underlying facts in order to decipher whether the fees incident to the
hostile takeover were for current defense of the company or for an ultimate corporate change with benefits lasting
into the future. See id. at 487–92.
Our task here is easier than in Staley. The taxpayer points us to no decision in conflict with Webb, where payments
made to satisfy an obligation directly assumed as part of a bargained-for acquisition have not been capitalized as
part of the purchase price of the asset. Regardless, applying the pragmatic approach called for in Staley results in
the same outcome, and is implicit, if not explicit, in the tax court’s opinion. 4 The record consists of three sets of
stipulated facts with dozens of attendant exhibits and a day-long trial transcript in which ITW presents seven
witnesses. The tax court’s opinion coalesced that testimony and documentary evidence into findings of fact, which
ITW, by its own admission, embraces. From those facts and the arguments advanced by the parties, the tax court
deduced that this was not a case in which the general rule articulated in Webb would not apply.
Looking at the facts, we agree. The ultimate goal of the pragmatic assessment advanced by Staley is to decode
whether an expenditure is ordinary or capital in nature. Although ITW argues that paying $16 million more than the
Lemelson lawsuit was allegedly worth could have no positive impact on the future of the company, it loses sight of
the fact that what it got in exchange for its obligation to pay the judgment was the DeVilbiss assets. In this way,
the Lemelson judgment was ““incurred for the purpose of changing the corporate structure for the benefit of future
operations”” and must be capitalized. Staley, 119 F.3d at 489 (quoting INDOPCO, 503 U.S. at 89). As stated by the
court in United States v. Smith, observing that the substance, not the form of the transaction governs when
determining tax treatment of a settlement paid to a former employee:
If the corporation at its inception assumed a contingent obligation to pay [the employee], it is that
assumption of liability which obligated the corporation and not any subsequent legitimate business
purpose. In other words, the corporation did not have to pay because of the unfavorable judgment or
because its directors deemed payment advisable but rather the corporation paid because it assumed the
obligation when it became incorporated.
418 F.2d 589, 596 [24 AFTR 2d 69-5599] (5th Cir. 1969); see also Staley, 119 F.3d at 491 (noting that “the
substance of the transaction, not its form, is controlling” (citing Clark Oil & Refining Corp. v. United States, 473
F.2d 1217, 1220–21 [31 AFTR 2d 73-780] (7th Cir. 1973)). So too here it was not ITW’s failure to accept the
settlement offer that obligated it to pay the jury award, but its assumption of the lawsuit in order to acquire
DeVilbiss.
If we examine the events post-acquisition, as ITW urges, the result is still the same. ITW focuses our attention
primarily on its missed opportunity to settle the case, contending that had it only taken Lemelson up on his final $1
million offer, instead of staunchly placing its faith in its own valuation of the case, then the liability it acquired along
with the DeVilbiss assets would not have increased exponentially. It states, “[t]hus, a “pragmatic,” “real-life”
assessment of the facts demonstrates that ITW’s decision, made in the ordinary course of its business, to reject
Lemelson’s settlement offers was the proximate cause of the amount ultimately owed to Lemelson.” (Appellant’s
Opening Br. at 32.) Yet, the patent suit claimed damages for [pg. 2004-555] infringing robots sold from 1979 to
1985, years before ITW acquired DeVilbiss. ITW’s predecessor failed to accept Lemelson’s $500,000 settlement offer
in 1989. And, as noted by the patent trial court in upholding the jury’s finding of willfulness: “Defendant’s entire
course of conduct from its total disregard of Plaintiff’s 1975 letter to its unexplained failure to secure an
authoritative opinion until two months before trial, demonstrates an utter lack of concern over Plaintiff’s patent
rights.” (Tr. Ex. 19-J ¶ 23.) A pragmatic assessment of this case leads to the conclusion that the Lemelson lawsuit
was mishandled from the outset, arriving in ITW’s hands fully formed. ITW’s mistakes and missed opportunities had
little to do with the ultimate valuation placed on the matter by the jury.
III. Conclusion
For the foregoing reasons, the decision of the tax court is Affirmed.
1
Prior to ITW’s purchase of DeVilbiss, Champion had sold it to Eagle Industries, who then sold it to ITW. The
Lemelson lawsuit was pending throughout these transactions.
2
Only $6,956,590 of the $17 million judgment is at issue on appeal because (a) ITW capitalized $1 million in its tax
return; (b) the Commissioner conceded an allowance of $2,154,160 for post-acquisition interest and expenses; and
(c) the Commissioner conceded a reduction of $6,956,589 due to the sale of certain DeVilbiss assets acquired in the
1990 purchase.
3
ITW argued for deductibility on several different grounds before the tax court, abandoning all but its reliance on
Staley on appeal.
4
We find it curious that ITW would choose to attack Judge Cohen for failing to engage in the appropriate open- minded, fact-based inquiry advocated in Staley. Judge Cohen, who served as trial judge in the Staley case, as well
as here, dissented from the tax court opinion from which the Staley appeal was taken. A.E. Staley Mfg. Co. v.
Commissioner, 105 T.C. 166, 210 (1995) (Cohen, J., dissenting). It was her dissent that this Court cited
favorably in its ruling reversing the tax court. See Staley, 119 F.3d at 491 n.8. And, in her closing instructions to the
parties about their post-trial briefs in the present matter, she discusses Staley and its possible implications,
describing her involvement in that case. (Tr. at 214–15.)
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Week 3 Research Project (Set #1)
DeVry University Acct 429
RESEARCH ESSAY ASSIGNMENT 1
As we covered in Weeks 2 and 3, the passive loss limitation rules impose real limitations on the
ability of owners of certain types of ventures to take losses from those ventures and use them
to reduce other income. That hardly means, however, that people don’t try. One such area
often involves various oil and gas ventures. Often operated as publicly traded partnerships,
sophisticated investors often purchase limited partnership interests in these ventures. They
are, however, subject to a particularlyrestrictive set of passive loss limitation rules. Locate at
least three such oil and gas publicly traded partnerships on the web that are marketed to new
investors. Describe the benefits that the promoters of each of these partnerships claim will
result from the investments and describe the disclaimers, if any, that they provide detailing
what limitations may be placed on the losses.
NOTE: You must either (1) submit complete citations to these online resources so that your
instructor may find these studies online or (2) submit complete copies of these online
resources with your submission. Failure to do so will result in a zero for the assignment.
PLEASE RESEARCH THIS ISSUE ON THE INTERNET AND COMPOSE AN ESSAY INCLUDING YOUR
ANALYSIS OF THE ISSUE (20 POINTS).
__________________________
TAX PRACTISES AND RESEARCH
Name:

Institution:

Date:

The paper begins by giving an insight on tax laws; specifically stress has been put on tax research performance and its importance for tax practices. It gives the current and strategic contexts on mechanisms being put in place to ensure implementation of the tax laws. This is preceded by a slight definition and discussion on terminologies that the paper uses in the body. Some of the ideologies that the paper looks at include the mission and objective that the laws have which form the main objectives of the tax laws practice process. It also looks at the goals that each individual composite bodies and its institutions has set so as to attain them successfully in the given time periods. These goals are the ones that the countries use in their daily operations. The paper will look into the key competencies of the law that give them a competitive edge to overcome the vice of law contravention. The paper also provides all the complex planning processes that are accompanied by explanations that are applicable in the case of internal revenue authorities. Moreover, details of the audit conducted on sample cases, the assessment and arguments have been done in which the countries departments and institutions operates. A stakeholder analysis has to be conducted in order to come up with various benefits that a country can attain by following the law research practices. The paper also looks at the current procedures of the countries institutions in order to come up with a means of solving the problems stemming from the strategy. The paper has also come up with a future strategy that is relevant to the law in the near future and the long run. The paper also delves into the role and responsibilities that are requisite for the successful enactment and implementation of the strategies formulated for long-term eradication of contradiction of the law. Finally, the paper looks at the resources that have to be in availability for the successful implementation of the newly formulated mechanisms for the US tax law institutions in order or ensure that the outcome is successful.
Introduction
The process performing tax research normally for any countries and its institutions and definitely is an important part of tax practice (Raabe, Whittenburg, Sanders, & Sawyers, 2011). Together with planning, compliance and litigation forms the basics of the tax practices. It is actually a common belief among tax practitioners that it forms the most interesting part of tax practices. The common definition is that tax research is a process that simply involves the act of obtaining information and integrating its basics to approach and answer a specific question. However, the relation, whether planning, compliance or litigation the process of tax research plays a huge role.
The research is a pervasive undertaking. It involves identification of the tax issues, collecting any composite and related information (Everett, Hennig, & Nichols, 2008). Together, an assessment is made to arrive at a legible conclusion. The various, courts cases, rules and regulation integrated with the IRS pronouncement forms a major building block for the right executions and case treatments.
Normally, the tax law is dynamic (Pope, Anderson, Ford, Robert, John, & Joseph, 2005). This therefore requires the practitioner to keep up to date on his or her research. This plays a huge role in ensuring that it’s current and has not been affected by any recent developments.
The following is a review on sample cases involving tax law practice. An analysis is done on the cases then a conclusion is drawn through a tax research memorandum.
1st assignment
Tax file memorandum
Relevant facts
Our client, Peaceful Pastures Funeral Homes, Inc provides funeral services by providing aggregate goods to its customers through the accrual basis taxpayer system. The case in review has sprung out following the sudden rise of cost of goods and services in recent years. This consequently has left many of the Peaceful customers struggling to meet the bills. Meanwhile, they have opted for goods and services that are more affordable, a situation that has impacted Peaceful sales negatively.
In an attempt to counter the situation, Peaceful has come up with a mechanism that aims to facilitate funeral goods and services by the customers. The program entails the customers making prior payments for the goods and services of which the advance contributions will stand in at the time of their death. The payment is significantly characterized by a discount. Also, the customer, the contracts purchaser’s are entitled to a refund on any request at any time until the goods and services are made available to them. Ultimately the system being an accrual basis, peaceful has integrated the payments and the incomes for the period of the funeral service are offered.
Specific issues
However, this year Peaceful has been hit by the tax authorities. An audit was carried out by the IRS and an audit notice was sent to Peaceful. The details of the audit revealed that IRS contended Peaceful’s income recognition system. Their view was that the Peaceful’s program constitutes prepaid income must be included in the overall income and thereafter taxed in the earned year. On the other hand Peaceful is in an opposite view and is contesting the IRS view.
Support and analysis
Peaceful Pastures Funeral Homes, Inc argument can be analyzed with reference to the case, COMMISSIONER OF INTERNAL REVENUE, PETITIONER. V. INDIANAPOLIS POWER & LIGHT CO., Cite as 65 AFTR 2d 90-39(110 S.Ct.589), 01/09/1990, Code Sec(s) 61.
The case took place at the US Supreme court and was based on time for reporting income, specifically prepaid income.
The history of the case referred to the respondent Indianapolis Power and Light Co. (IPL). The company is classified under Indiana utility regulated and accrual-basis taxpayers. Essentially, its customers make prior deposits as a guarantee of future payment of the incurred electric bills. A major characteristic of the scheme is that, in the period preceding the termination of the service, the authentically acquired customers can get a refund of their deposits or settlement of the future bills against the amount.
With that, the point of concern arises, despite the IPL being in the control of the deposits, the company does not treat them as income but considers them as current liabilities in its record books. On the other hand, following the audit, the petitioner i.e. the commissioner of internal revenue stated insufficiency of the system. His argument was that the deposits constitute prior payment for the electricity and thus should consequently have been taxed during the year of receipt.
Nonetheless, the case ruling was in favor of IPL. Its petition was affirmed by the Court of Appeals. It held that the main purpose of the deposits was to serve as security unlike the argument of it being prepayment. The advance payment for the electricity was refuted to be part of IPL taxable income, as the customer making the deposit did not guarantee commitment to buy the electricity bill.
Conclusion
Meanwhile, for our case study, the case in contention involved IRS and the Peaceful Pastures Funeral Homes, Inc. making comparison to the above IPL case, the Peaceful argument would always carry the day in a court of law. The deposits, the advance payment for its funeral goods and services cannot be considered to be part of its taxable income, as the customer making the deposit did not guarantee commitment to buy the goods and services upon death.

2nd assignment
Tax file memorandum
Relevant facts
The research is based on two firms, MegaCorp and Little, Inc. MegaCorp, Inc made a purchase of all Little, Inc assets. Meanwhile, as part of the agreement MegaCorp took charge of some of little’s liabilities. Top on the list was spiteful patent infringement case against Ideas, Inc. in contrast to the expert s probability estimation, the Jury found the violation to have happened thus Ideas was to be awarded the damages of $5 million. Meanwhile, following the ruling, a turn of events began. From the ruling, MegaCorp paid the fine and consequently made deduction of the payment as an ordinary and obligatory business expense stipulated under § 162
Specific issues
An audit was done by the IRS and contravened the characterization. Accordingly, the IRS classified the penalty of $5 million as a capital expenditure. They went ahead to disallow the deduction according to the stipulation of § 263.
Support and analysis
Consequently, the bone of contention is whether IRS contradiction is right or whether MegaCorp was entitled to the deduction. For our case argument, reference will be made to the Internal Revenue Code, specifically under § 162 Trade or business expenses which considers at deductions.
According to section (f) that entails Fines and penalties, the IRS will carry the day in a case of law. The section states that no deduction shall be allowed under subsection (a) for payment to the government on any violation of the law (Commerce Clearing House incorporated, 2007).
In the case, Illinois Tool Works Inc. et al. v. Commissioner, 117 TC 39, Code Sec(s) 162; 263, the Tax court and Board of Tax Appeals, report on business deductions the Illinois company assumed liabilities.
Conclusion,
Consequents MegaCorp case involved a liability characterized as assumed deductable business expense. In the actual sense, the capital acquisition constituted capital expense which in the end became part of the expense acquired on cost basis of the property. In conclusion, the case will be closed and the distinguishing appeal rejected.

3rd assignment
Tax practices and reaearch
The process performing tax research normally for any countries and its institutions and definitely is an important part of tax practice. Together with planning, compliance and litigation forms the basics of the tax practices (Foth, 2007). It is actually a common belief among tax practitioners that it forms the most interesting part of tax practices. The common definition is that tax research is a process that simply involves the act of obtaining information and integrating its basics to approach and answer a specific question. However, the relation, whether planning, compliance or litigation the process of tax research plays a huge role.
The research is a pervasive undertaking (Smith, Harmelink, & Hasselback, 2008). It involves identification of the tax issues, collecting any composite and related information. Together, an assessment is made to arrive at a legible conclusion. The various, courts cases, rules and regulation integrated with the IRS pronouncement forms a major building block for the right executions and case treatments.
Normally, the tax law is dynamic (Oats, 2012). This therefore requires the practitioner to keep up to date on his or her research. This plays a huge role in ensuring that it’s current and has not been affected by any recent developments.

Meanwhile, as outlined in Chapter 2 of our course textbook, tax law is development process involves an entangled collection of different governmental entities (Pechman, 1987). The process is initiated by the Congress. It starts by enacting the tax Code as statutory law. Secondly is the Treasury Department. Normally it is tasked with the process of tax Code implementation. In the process, in the course of doing so, a number of documents and materials are developed in the end supports the common taxpayers in the overall Treasury Department’s understanding of the Interpretation of the code and its composite Regulations (Everett, Hennig, & Nichols, 2008).
In response to that, the Internal Revenue Service plays a major and unswerving responsibility for the ultimate implementing and assessing the tax Code and collection of the applicable tax requirements from taxpayers (Pope, Anderson, Ford, Robert, John, & Joseph, 2005).
By and by, in the relentless course of its duties, a number of materials are developed that includes Revenue Procedures, Revenues rulings and Private Letter. The Rulings are used to aid in the ultimate understanding of the tax laws.
Finally are the federal courts. They normally come up with findings and decisions on cases entailing taxpayer’s contests and the government’s general understanding of the tax laws. The Federal courts in the end gradually set the pace in binding the interpretation of what the tax laws perennially provide. All of these primary resources are important in performing the tax research. The primary sources work together with the secondary sources materials of tax law, in the end providing various in formations to the organizations and the various publishers
Sources of the tax laws
The law’s enactment is diverse and they often serve vast subjects (Everett, Hennig, & Nichols, 2008). The sources of these laws are normally classified into two broad categories. This includes the law and the official interpretation of the law. The law is a composite of Act of congress, tax treaties and the constitution. They are normally referred to as the statutory laws. This forms the basis for interpretation by the internal Revenue service. In cases where a contradiction occurs between the government and the taxpayers over settlement, the courts play the role of the final arbiter.

Conclusion
The process of tax research practice is a diverse process. Normally it entails an aggregate of various departments. From the above study review, specifically the sample cases, the research process provides a basis for assessment and the end decision making with regard to the tax laws. The paper also delves into the role and responsibilities of the various composite bodies that are requisite for the successful enactment and implementation of the strategies formulated for long-term working of the tax law.
Bibliography
Commerce Clearing House incorporated. (2007). U.S. Master Tax Guide. Riverwood,Illinois: CCH.
Everett, J. O., Hennig, C. J., & Nichols, N. (2008). Contemporary Tax Practice: Research, Planning and Strategies. Vancouver: CCH.
Foth, E. C. (2007). Federal Tax Study Manual (2008). CCH: Riverwoods, Illinois.
Oats, L. (2012). Taxation: A Fieldwork Research Handbook. Paris: Routledge.
Pechman, J. A. (1987). Federal Tax Policy. Brookings Institution Press.
Pope, T. R., Anderson, K. E., Ford, A., Robert, B., John, K., & Joseph, R. (2005). Prentice Hall’s Federal Taxation 2006: Principles. Upper Saddle River, New Jersey: Prentice Hall.
Raabe, W. A., Whittenburg, G. E., Sanders, D. L., & Sawyers, R. B. (2011). Federal Tax Research. London: Cengage Learning.
Smith, E. P., Harmelink, P. J., & Hasselback, J. R. (2008). Federal Taxation: Comprehensive Topics 2009. CCH.

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