Let's discuss a famous tax case, and
then I will ask you how you would decide a second case based on the decision in
the first.
We are going back to 1944, and Lewis received a
$22 thousand bonus. He reported it on
his 1944 tax return. It turns out that the bonus had been calculated
incorrectly, and he returned $11,000 in 1946. Lewis argued that the $11,000 was
mistake, and as a mistake it should not have been taxed to him in 1944. He
should be able to amend his 1944 return and get his taxes back. This had an
extra meaning since his tax rate in 1946 was lower (remember: post-war), so if
he could not amend 1944 he would never get all his taxes back.
The IRS took a very different stand. It pointed
out that the tax Code measures income annually. While arbitrary, it is a
necessary convention otherwise one could not calculate income or the tax
thereon, as there would (almost) always be one or more transactions not resolving
by the end of the year. Think for example of writing a check to the church on
December 31 but the check not clearing until the following year. The Code
therefore taxes income on a "period" concept and not a "transactional"
concept. With that backdrop, Lewis would have a deduction in 1946, when he
returned the excess bonus.
The case went to the Supreme Court, which found
that the full bonus was taxable in 1944. The Court reasoned that Lewis had a "claim
of right," a phrase which has now entered the tax literature. It means
that income is taxable when received, if there are no restrictions on its disposition.
This is true even if later one has to return the income. The reasoning is that
there are no limits on one's ability to spend the money, and there is also no
immediate belief that it has to be repaid. Lewis had a deduction in 1946.
Looks like the claim of right is a subset of
"every tax year stands on its own."
Let's roll into the 1950s. There was a company
by the name of Skelly Oil. During the years 1952 through 1957 it overcharged customers
approximately $500 thousand. In 1958 it refunded the $500 thousand.
You can pretty much see the Lewis and claim-of-right issue.
But there was one more fact.
Skelly Oil had deducted depletion of 27.5%.
Depletion is a concept similar to depreciation, but it does not have to be tied
to cost. Say you bought a machine for $100,000. You would depreciate the
machine by immediately expensing, allocating expense over time or whatever, but
you would have to stop at $100,000. You cannot depreciate more than what you
spent. Depletion is a similar concept, but without that limitation. One would
deplete (not depreciate) an oil field, for example. One would continue
depleting even if one had fully recovered the cost of the field. It is a nice
tax gimmick.
Skelly Oil had claimed 27.5% depletion against
its $500,000 thousand or so, meaning that it had paid tax on a net of $366,000.
Skelly Oil deducted the $505,000 thousand.
Skelly Oil had a leg up after the Burnet
v. Sanford & Brooks and Lewis
decisions, as every tax year was to stand on its own. It refunded $505,000,
meaning it had a deduction of $505,000. Seemed a slam dunk.
The IRS said no way. The $505,000 had a trailer
attached - that 27.5% depletion - and wherever it went that 27.5% went. The
most Skelly Oil could deduct was the $366,000.
But the IRS had a problem: the tax Code was
based on period reporting and not transactional reporting. The 27.5% trailer analogy
was stunning on the big screen and all, but it was not tax law. There was no
ball hitch on the $505,000 dragging depletion in its wake.
Here is the Supreme Court:
[T]he Code should not be interpreted to allow respondent 'the practical equivalent of double deduction,' *** absent a clear declaration of intent by Congress."
The dissent argued (in my words):
So what? Every year stands on its own. Since when is the Code concerned with the proper measurement of income?
Odd thing, though: the dissent was right. The Lewis decision does indicate that Skelly
Oil had a $505,000 deduction, even though it might not have seemed fair. The
Court reached instead for another concept - the Arrowsmith concept.
[T]he annual accounting concept does not require us to close our eyes to what happened in prior years."
There is your ball hitch. The concept of "net
items" would drag the 27.5% depletion into 1958. "Net items"
would include revenues and deductions so closely related as to be inseparable.
Like oil revenues and its related depletion deduction.
The Court gave us the following famous quote:
In other situations when the taxes on a receipt do not equal the tax benefits of a repayment, either the taxpayer or the Government may, depending on circumstances, be the beneficiary. Here, the taxpayer always wins and the Government always loses."
And over time the Skelly Oil case has come to be interpreted as disallowing a tax
treatment where "the taxpayer always wins and the Government always
loses." The reverse, however, is and has always been acceptable to the
Government.
But you can see something about the evolution of
tax law: you don't really know the law until the Court decides the law. Both Lewis and Skelly Oil could have gone either way.
Now think of the tax law, rulings and
Regulations being published every year. Do we really know what this law means,
or are we just waiting our turn, like Lewis and Skelly Oil?
