HILLSBORO NATIONAL BANK, PETITIONER V. COMMISSIONER OF INTERNAL
REVENUE

   UNITED STATES OF AMERICA, PETITIONER V. BLISS DAIRY, INC.

   No. 81-485

   No. 81-930

   In the Supreme Court of the United States

   October Term, 1981

   On Writs of Certiorari to the United States Courts of Appeals for
the Seventh and Ninth Circuits

   Brief for the Commissioner in No. 81-485 and the United States in
No. 81-930

            TABLE OF CONTENTS
   Opinions below
   Jurisdiction
   Statutes and regulation involved
   Statement
   Summary of argument
   Argument:
      I. The tax benefit rule requires a taxpayer to restore to
          income previously deducted items once subsequent events
          establish the invalidity of the factual premise upon which
          the prior year's deduction was claimed, whether or not the
          taxpayer actually recovers money or property
          A. The tax benefit rule is a necessary element of
             the annual accounting system
          B. The courts developed the tax benefit rule in order
             to offset the benefit of a deduction for expenses
             or losses which subsequent events establish will not
             be incurred
      II. The personal property taxes previously deducted
          by Hillsboro Bank should be restored to income when
          the amounts it paid into escrow were refunded to its
          shareholders on whose behalf they had been deposited
      III. The amounts previously deducted by Bliss Dairy
          that are attributable to cattle feed unconsumed in its
          business and distributed to its shareholders on
          liquidation should be restored to its taxable income
          for its year of liquidation
          A. A corporation's distribution of previously deducted
             cattle feed to its shareholders refutes the
             assumptions underlying the corporation's claim to
             deductions for the cost of that feed
          B. At all events, even if an "actual recovery" is
             required for the application of the tax benefit
             rule, Bliss Dairy enjoyed such a recovery
   Conclusion
   Appendix

                            OPINIONS BELOW

   No. 81-485.  The opinion of the Tax Court (H. Pet. App. A-21 to A/
48) /1/ is reported at 73 T.C. 61.  The opinion of the court of
appeals (H. Pet. App. A-1 to A-20) is reported at 641 F.2d 529.

   No. 81-930.  The opinion of the district court (B. Pet. App. 1a) is
not reported.  The opinion of the court of appeals (B. Pet. App.
2a-5a) is reported at 645 F.2d 19.

                             JURISDICTION

   No. 81-485.  The judgment of the court of appeals was entered on
February 25, 1981 (H. Pet. App. A-47 to A-48).  A petition for
rehearing and rehearing en banc was denied on June 9, 1981 (H. Pet.
App. A-49 to A-50).  The petition for a writ of certiorari was filed
on September 5, 1981, and granted on January 18, 1982.  The
jurisdiction of this Court rests on 28 U.S.C. 1254(1).

   No. 81-930.  The judgment of the court of appeals was entered on
May 11, 1981 (B. Pet. App. 6a).  The government's petition for
rehearing was denied on July 31, 1981 (B. Pet. App. 7a).  On October
2, 1981, Justice Rehnquist extended the time within which the
government could file a petition for a writ of certiorari to November
21, 1981.  The petition was filed on November 16, 1981, and granted on
January 18, 1982.  The jurisdiction of this Court rests on 28 U.S.C.
1254(1).

                   STATUTES AND REGULATION INVOLVED

   The relevant provisions of Sections 164, 332, 333, 334, 336 and 337
of the Internal Revenue Code of 1954 (26 U.S.C (& Supp. III)), and
Section 1.164-7 of the Treasury Regulations on Income Tax (1954 Code)
(26 C.F.R.), are set forth in the Appendix, infra, 1a-4a.

                          QUESTIONS PRESENTED

   No. 81-485.  Whether the tax benefit rule required a bank to
include in gross income the amount of a state tax that it had paid in
a previous taxable year on behalf of its stockholders, and for which
it had taken a federal income tax deduction, when it was subsequently
determined that the state tax was not owing and the tax was refunded
directly to the bank's stockholders in the taxable year at issue.

   No. 81-930.  Whether the tax benefit rule required a liquidating
corporation to include in gross income for the year of its
liquidation, an amount equal to the value of uncomsumed cattle feed it
distributed to its shareholders, where the corporation had previously
deducted the cost of that feed in full, and where the shareholders
acquired a "stepped-up" basis in the feed enabling them to claim a
further deduction for the feed when it was consumed during their
subsequent operation of the business in non-corporate form.

                               STATEMENT

   No. 81-485.  Petitioner Hillsboro National Bank is a national
banking association with its principal place of business in Hillsboro,
Illinois.  Prior to 1971, the stockholders of incorporated banks
located within Illinois were subject to a personal property tax on the
value of their shares.  Ill. Ann. Stat. ch. 120, Section 557
(Smith-Hurd 1970).  The banks, however, were themselves required to
retain dividends sufficient to pay those taxes.  Ill. Ann. Stat. ch.
120, Section 558 (Smith-Hurd 1970).  Rather than retaining dividends,
Illinois banks customarily paid the taxes on behalf of their
stockholders (H. Pet. App. A-2, A-23 to A-24).

   In 1970, Illinois amended its constitution, effective January 1,
1971, to prohibit ad valorem taxation on personal property owned by
individuals.  In July 1971, however, the Illinois Supreme Court held
the amendment invalid on the ground that it violated the Equal
Protection Clause of the Fourteenth Amendment to the United States
Constitution.  Lake Shore Auto Parts Co. v. Korzen, 49 Ill. 2d 137,
273 N.E.2d 592 (1971).  After this Court granted certiorari in that
case (405 U.S. 1039), Illinois enacted a statute directing that the
disputed property taxes be deposited in an interest-bearing escrow
account pending final resolution of the Lake Shore case, and further
providing that full repayment would be made to the taxpayers "for whom
such tax payments are placed in escrow" if the taxes were "ultimately
held to be invalid" (Ill. Ann. Stat. ch. 120, Section 676.01
(Smith-Hurd Cum. Supp. 1981)) (H. Pet. App. A-3, A-26 to A-27).

   On July 7, 1972, Hillsboro Bank paid $26,110.32 to the County
Collector of Montgomery County, Illinois, in satisfaction of the 1971
personal property taxes owed by its individual stockholders on their
bank shares.  On its 1972 tax return, the Bank claimed a deduction for
these tax payments pursuant to Section 164(e) of the Internal Revenue
Code of 1954 (26 U.S.C.) (H. Pet. App. A-3, A-4, A-23 to A25).  /2/

   In February 1973, this Court reversed the Illinois Supreme Court,
holding that the Illinois constitutional amendment prohibiting the
imposition of such taxes was valid.  Lehnhausen v. Lake Shore Auto
Parts Co., 410 U.S. 356.  Acting upon the advice of the Illinois
States Attorney and the Illinois Department of Local Government
Affairs, the County Treasury of Montgomery County, Illinois, thereupon
refunded $26,697.79 (representing the $26,110.32 in erroneously
collected personal property taxes, plus $587.47 in accrued interest)
directly to the Bank's individual stockholders.  The Bank did not
include any portion of the refunded amount in gross income as reported
on its return for its taxable year ended December 31, 1973 (H. Pet.
App. A-27 to A-29).

   On audit, the Commissioner of Internal Revenue determined that the
entire sum refunded to the shareholders was includible in the Bank's
gross income for 1973 under the tax benefit rule because the tax
refund in 1973 was inconsistent with the Bank's claimed deduction of
the state tax in 1972.  In this proceeding brought by the Bank for
redetermination of the Commissioner's deficiency, the Tax Court ruled
that the amount previously deducted (but not the accrued interest) was
properly included in the Bank's income for 1973 under the tax benefit
rule.  The Court reasoned that otherwise the Bank would be able to
retain the benefit of a deduction for what was, in ultimate effect, a
dividend distribution (H. Pet. App. A-21 to A-46).

   The court of appeals affirmed, with one judge dissenting (H. Pet.
App. A-1 to A-20).  Adhering to its earlier decision in First Trust
and Savings Bank v. United States, 614 F.2d 1142 (7th Cir. 1980), in
which it had applied the tax benefit rule in almost identical
circumstances, the court held that the tax benefit rule should be
applied where "there is either an actual recovery of a previously
deducted amount or some other event inconsistent with the prior
deduction" (H. Pet. App. A-7).  It concluded that the latter ground
"applies foursquare in this case" because the state tax refund had
"transformed a tax payment deductible under Sec. 164(e) into a
nondeductible cash dividend to the Bank's stockholders" (H. Pet. App.
A-8).

   No. 81-930.  Respondent Bliss Dairy, Inc. was a closely held
Arizona corporation engaged in the business of operating a dairy.  It
kept its books and filed its income tax returns using a cash method of
accounting, with a fiscal and taxable year beginning on July 1 and
ending June 30.  During its taxable year ending June 30, 1973, Bliss
purchased $150,199 worth of cattle feed for use in its dairy
operations.  In accordance with its cash method of accounting, it
deducted the full cost of the feed from its gross income as a business
expense on its 1973 return, even though a substantial portion of the
feed had not yet been consumed by the end of that year (B. Pet. App.
2a-3a).

   On July 2, 1973, two days into the following taxable year, Bliss
adopted a plan of liquidation pursuant to Section 333 of the Internal
Revenue Code of 1954.  /3/ In accordance with that plan, Bliss, during
the month of July 1973, distributed all of its assets pro rata to its
shareholders, who thereafter continued to operate the dairy business
in non-corporate form.  Among the assets so distributed was the
unconsumed cattle feed that Bliss deducted as an expense for the
preceding taxable year.  That feed had an adjusted basis in the hands
of the corporation of zero because it had previously deducted the full
cost of the feed.  As a result of the liquidation, however, the
shareholders acquired "stepped-up" tax bases in the feed, thereby
allowing them the benefit of further deductions on their individual
tax returns for the period in which the feed was actually consumed (B.
Pet. App. 3a).  /4/

   On audit of Bliss' federal income tax return for its final taxable
year (July 1, 1973 through July 31, 1973), the Commissioner of
Internal Revenue increased Bliss' gross income by $60,000,
representing his determination of the value of the unconsumed feed
that Bliss distributed to its shareholders.  /5/ Bliss paid the
resulting assessment and brought this refund suit in the United States
District Court for the District of Arizona.  Although the district
court agreed that the Commissioner's determination was correct, it
considered itself bound by the Ninth Circuit's prior decision in
Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (1963), and
stated that it would follow that case "until such time as it is
overruled" (B. Pet. App. 1a).

   The court of appeals affirmed on the authority of its prior
decision in South Lake Farms.  There, it had declined to apply the tax
benefit rule in comparable circumstances involving the liquidation of
a subsidiary corporation into its parent under Section 322 of the
Code.  In adhering to its decision in South Lake Farms, the court of
appeals acknowledged that "(r)ecent decisions in the Courts of Appeals
of other circuits are in conflict with our holding in South Alke
Farms" (B. Pet. App. 4a).  /6/

                          SUMMARY OF ARGUMENT

                                   I

   A. One of the fundamental principles upon which the federal income
tax is based is the annual accounting system, which draws arbitrary
lines between taxable periods.  In so doing, the annual accounting
system necessarily rejects a transactional approach under which tax
consequences await the completion of each particular transaction,
rather than the close of a taxable period.  The firm lines of
demarcation between taxable periods will inevitably produce situations
in which the taxpayer may be required to report income or may be
entitled to claim deductions for a particular year even though events
occurring in a subsequent year may affect the amount of income
actually enjoyed or the outlays or losses ultimately incurred.  The
proper remedy for taking account of such changed circumstances is not
to amend or modify the original return, but rather to reflect the
change on the return covering the later period during which the
offsetting events actually occurred.  See, e.g., Burnet v. Sanford &
Brooks Co., 282 U.S. 359, 365 (1931);  Healy v. Commissioner, 345 U.S.
278 (1953).

   In response to the requirements of the annual accounting system,
the courts have developed the "tax benefit rule" to deal with such
subsequent year reportings.  The rule is designed to ensure a measure
of tax parity in the effect of an earlier deduction and later
correcting entry.  Under the tax benefit rule, the required correction
for expenses that are deducted but not ultimately incurred is for
income in the later year to be increased by the amount of the prior
deduction.

   The tax benefit rule at issue in these cases requires the
restoration of a prior year's deduction to income when subsequent
events establish the invalidity of the factual premise on which the
prior year's deduction was claimed.  In Hillsboro National Bank, the
taxpayer-bank paid certain state personal property taxes on behalf of
its shareholders and claimed a deduction for those taxes in 1972.
After it was determined that the taxes were not due and owing, the
State refunded the taxes directly to the shareholders in 1973.  In
Bliss Dairy, the taxpayer-corporation purchased cattle feed for use in
its business.  In accordance with an accounting convention, it
deducted the full cost of the feed as a business expense.  In the
following tax year, however, the corporation liquidated and
distributed unconsumed cattle feed for which it had previously taken a
deduction.  These after-arising inconsistent events -- the refund of
the state taxes and the distribution of the unconsumed feed --
eliminate the factual premises upon which the taxpayers claimed the
prior years' deductions.  If a state tax turns out not to be due,
there is no justification for the bank's retaining the benefits of a
deduction premised on its payment.  And if cattle feed will not be
used in a corporation's business, the corporation must restore the
deduction to its income when the fact of non-consumption by the
corporation becomes apparent.  In sum, the subsequent events in both
cases demonstrate that the taxpayers were not entitled to the
deductions that they originally claimed.

   B. The taxpayers here acknowledge the existence of the tax benefit
rule but resist its application in these cases on the ground that they
did not enjoy an actual recovery of money or property.  Thus,
Hillsboro Bank argues that it should not be required to restore its
deduction for state taxes to income because the state tax refund was
paid to its shareholders, rather than to itself.  Likewise, Bliss
Dairy contends that the deduction for unconsumed cattle feed should
not be restored to income because it received nothing when it
distributed the feed to its shareholders upon liquidation.

   But both taxpayers misjudge the purpose of the tax benefit rule.
That rule does not depend upon an actual recovery of money or
property.  The early cases that developed the tax benefit rule did not
turn upon the identification and taxation of economic benefits that
could be considered to be actual current taxable income.  Rather, the
courts recognized that the tax benefit rule is a remedial device
designed to assure that a taxpayer's income over a period encompassing
several taxable years is accurately reflected where subsequent events
establish that no loss or expenses will actually be incurred.  For
example, an early case required, on tax benefit principles, a taxpayer
to restore to income a previously claimed depletion deduction taken in
anticipation of exhaustion of her property's oil reserve when the
lease she had granted expired without any production ever having taken
place.  Barnett v. Commissioner, 39 B.T.A. 864 (1939).  /7/ There, it
is plain that no "actual recovery" of money or property occurred.  The
taxpayer had to recognize income in the current year not because she
actually received anything that might be characterized as income in
the current year for she plainly had not.  Rather, income recognition
was necessary to balance out the prior deduction that was allowed in
anticipation of events that did not ultimately occur.  As the Board of
Tax Appeals stated, "(w)hen some event occurs which is inconsistent
with a deduction taken in a prior year, adjustment may have to be made
by reporting a balancing item in income for the year in which the
change occurs" (39 B.T.A. at 867).

   Hence, the tax benefit rule is a mechanism for putting right the
imbalance caused by a change in circumstances undermining the premise
on which previously claimed deductions were based.  Thus, the
taxpayers in these cases are treated as realizing income only because
they deducted amounts that prove to have exceeded their actual loss or
cost.  Since the basis of the tax benefit rule is the need to correct
the income distortion caused by a taxpayer's having claimed a
deduction which, in light of hindsight, exceeded his actual expenses,
it follows that the rule should apply on the occurrence of any event
that refutes the correctness of the factual assumptions underlying a
previously claimed deduction.  Although an actual recovery is the
usual type of event that triggers application of the tax benefit rule,
the cases establish that such recovery is not the only type of event
that requires restoration of a prior year's deduction.

                                  II

   Viewed from this perspective, it is plain that Hillsboro Bank must
restore its prior deduction for state taxes to its income, even if it
is not deemed to have received an actual recovery of money or
property.  Here, the refund of the amounts previously paid on behalf
of the Bank's shareholders for satisfaction of the personal property
tax liability negates the factual premise upon which the Bank
previously deducted such amounts pursuant to Sections 164(e) and
461(f) of the Code.  In enacting the latter provision permitting the
current deduction of contested liabilities, Congress explicitly stated
its understanding that any "overstatement of the deduction" would be
restored to income "in the year in which the liability is finally
determined" S. Rep. No. 830, 88th Cong., 2d Sess. 100 (1964).  Hence,
the tax benefit principle was ratified by Congress as applicable to
the circumstances here.

   The fact that the refund was paid directly to the shareholders,
rather than to the Bank alone, or to the Bank and its shareholders
jointly, is not a sufficient basis for allowing the Bank the
continuing benefit of its prior deduction.  The particular identity of
the recipient of the refund is of no moment.  For purposes of the tax
benefit rule, the critical fact is that the determination of
nonliability and the consequent tax refund (whether to the Bank or to
its shareholders) are events that are inconsistent with, and eliminate
the justification for, the allowance of a deduction to any party under
Section 164.  Indeed, as the court below recognized (H. Pet. App.
A-8), the ultimate result was to transform the escrow deposit into a
dividend from the Bank to the shareholders.  Thus, unless the tax
benefit rule applies to restore the prior deduction to the Bank's
income, the Bank will obtain the wholly improper benefit of a tax
deduction for a dividend distribution to its shareholders.  The
corrective tax benefit rule is designed to prevent such an anomaly.
/8/

                                  III

   The corrective tax benefit rule likewise applies to Bliss Dairy.
On its return for its taxable year ending June 30, 1973, Bliss Dairy
deducted the full cost of $150,199 worth of cattle feed that it had
purchased in that year.  This deduction was based on the assumption
that the feed would ordinarily be consumed within a relatively short
time in the course of the operation of its business.  However, only
$93,634 of the feed was consumed in the year for which the deduction
was claimed.  On the second day of the next taxable year, Bliss Dairy
liquidated and distributed the remaining $56,565 worth of
previously-deducted feed to its shareholders.  This distribution in
kind of unconsumed feed eliminated the basis for the original
assumption underlying Bliss Dairy's earlier deduction, i.e., that the
feed would be consumed in the ordinary course of its business.  If
Bliss Dairy had used the feed for its shareholders' personally-owned
cattle, the deduction would be restored to its income.  Accordingly,
Bliss Dairy's liquidating transfer of the feed was likewise an
appropriate event for applying the tax benefit rule to require a
restoration of the amount deducted for the distributed feed in the
prior year.

   Indeed, the case for application of the tax benefit rule is
considerably enhanced by the fact that absent restoration of the
deduction, there will be a double deduction for the same cattle feed.
As this Court reaffirmed in United States v. Skelly Oil Co., 394 U.S.
678, 684 (1969), "the Code should not be interpreted to allow * * *
'the practical equivalent of double deduction' * * * , absent a clear
declaration of intent by Congress." But unless the tax benefit rule
applies in this case, the result would not simply be "the practical
equivalent" of a double deduction but a double deduction in fact.
Here, the shareholders of Bliss Dairy who continued its business in
noncorporate form took a "stepped-up" basis in the cattle feed
computed by reference to the basis of their stock in the corporation
under Section 334(c) of the Code.  They quite properly deducted the
amount of that basis when the feed was consumed in the course of their
business.  In a prior year, however, Bliss Dairy claimed a similar
deduction for the cost of the feed.  In these circumstances, Bliss
Dairy must restore to its own income the amount previously deducted
for that portion of the feed that was not ultimately used in its trade
or business but rather in the trade or business of its shareholders.

   Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (9th Cir.
1963), upon which the decision below relied, is not cogent authority
for the proposition that the tax benefit rule requires a recovery of
money or property.  There, in a prior decision the court of appeals
stated that "(n)owhere in the Code do we find an intent that gains to
the stockholders were to be attributed to the corporation, much less
that they were to be treated as ordinary income to the corporation"
(324 F.2d at 389).  But the court below misunderstood why Bliss Dairy
should be required to recognize income in the current taxable year.
The government is not seeking to attribute to Bliss Dairy the gains of
its shareholders.  Rather it is Bliss Dairy's own ordinary income that
the government seeks to restore to taxable income -- i.e., the income
that escaped tax in the prior taxable year as a result of the
deduction for cattle feed that would be consumed only in subsequent
periods.  Once subsequent events made it clear that the anticipated
event on which the deduction was based would not occur, such a
restoration to income is required under the tax benefit rule.  /9/

                               ARGUMENT

                                   I

 THE TAX BENEFIT RULE REQUIRES A TAXPAYER TO RESTORE TO INCOME
PREVIOUSLY DEDUCTED ITEMS ONCE SUBSEQUNET EVENTS ESTABLISH THE
INVALIDITY OF THE FACTUAL PREMISE UPON WHICH THE PRIOR YEAR'S
DEDUCTION WAS CLAIMED, WHETHER OR NOT THE TAXPAYER ACTUALLY RECOVERS
MONEY OR PROPERTY

   A. The Tax Benefit Rule Is A Necessary Element Of The Annual
Accounting System

   1. A fundamental principle upon which the federal income tax is
based is the annual accounting system.  See Section 441 of the
Internal Revenue Code of 1954.  As the Court stated in Burnet v.
Sanford & Brooks Co., 282 U.S. 359, 365 (1931), "It is the essence of
any system of taxation that it should produce revenue ascertainable,
and payable to the government, at regular intervals.  Only by such a
system is it practicable to produce a regular flow of income and apply
methods of accounting, assessment, and collection capable of practical
operation."

   The annual accounting system draws arbitrary lines between taxable
periods.  In so doing, it necessarily rejects a transactional approach
under which tax consequences await the completion of each particular
transaction, rather than the close of a taxable period.  Accordingly,
"(i)t is settled that each 'taxable year' must be treated as a
separate unit, and all items of gross income at and deduction must be
reflected in terms of their posture the close of such year." United
States v. Consolidated Edison Co., 366 U.S. 380, 384 (1961).  The firm
demarcation between taxable periods necessarily produce situations in
which the taxpayer may be required to report income or may be entitled
to claim deductions for a particular year even though events occurring
in a subsequent year may affect the amount of income actually enjoyed
or the liabilities or losses ultimately incurred.

   Since this Court's decision in Burnet v. Sanford & Brooks Co.,
supra, it has been established that the proper adjustment for such
changed circumstances is not to be made in the year in which the item
of income was originally reported or the deduction claimed, but rather
by means of a corrective entry for the year in which the change of
circumstance occurs.  For example, in North American Oil v. Burnet,
286 U.S. 417 (1932), this Court held that when a taxpayer recieves
income in one year under a "claim of right," that amount is includable
in gross income for the year of receipt, even though the taxpayer is
divested of the income in a subsequent year.  North American Oil made
equally clear that the subsequent divestment of such an item of income
would give rise to a deduction in the subsequent year.  As the Court
there explained, "(i)f in 1922 the Government had prevailed, and the
company had been obliged to refund the profits received in 1917, it
would have been entitled to a deduction from the profits of 1922, not
from those of any earlier year * * * " (id. at 424).  See also United
States v. Lewis, 340 U.S. 590 (1951);  Healy v. Commissioner, 345 U.S.
278 (1953);  United States v. Skelly Oil Co., 394 U.S. 678, 680-681
(1969).  See generally 1 B. Bittker, Federal Taxation of Income,
Estates and Gifts, Paragraphs 6.3.1 through 6.3.4 (1981).  /10/

   The tax benefit rule involved in these cases is the converse of the
claim of right doctrine established by this Court in North American
Oil and to which the Court adverted at the conclusion of its opinion
in that case.  For just as the claim of right doctrine requires the
reporting of income based upon the circumstances known to exist at the
end of the particular period, the tax benefit rule entitles a taxpayer
to enjoy the benefit of whatever deductions appear to be proper based
upon the circumstances that exist at the end of the taxable period.
In both cases, however, subsequent events require corrective
adjustments to be made in later years.  Thus, when a taxpayer receives
income subject to a claim of right and reports it in year 1, he may
claim a deduction for year 2 if he must return or relinquish the item
of income in that later year.  Conversely, where a taxpayer obtains a
tax benefit for a deduction claimed in year 1 and it is established in
year 2 that the anticipated loss or expense for which the deduction is
claimed will not be incurred, he must restore the deduction to income
in year 2.  See, generally, 1 B. Bittker, supra, Paragraph 5.7.1.

   As the tax benefit rule originally developed, it dealt primarily
with the inclusion in gross income of previously deducted amounts such
as debts that had been written off as worthless and that were later
collected.  See, e.g., Putnam National Bank v. Commissioner, 50 F.2d
158 (5th Cir. 1931).  Absent the prior deduction, there would of
course be no occasion for classifying the collection of a debt as a
taxable event.  Hence, a controversy early arose as to whether full
restoration to income of the previously deducted amount would be
justified to the extent the deduction had not led to a "tax benefit"
in the earlier year.  That question, however, was put to rest in 1942
with the adoption of Section 22(b)(12) (Act of Oct. 21, 1942, ch. 619,
56 Stat. 812) of the Internal Revenue Code of 1939 (26 U.S.C. (1952
ed.)) (the predecessor to Section 111 of the 1954 Code), which
specifically provided for the exclusion from income of subsequently
recovered bad debts, prior taxes and "delinquency amounts" to the
extent that prior credits or deductions did not give rise to an actual
tax benefit.  /11/ See Dobson v. Commissioner, 320 U.S. 489, 505
(1943).  Indeed, while the "inclusionary" principles outlined above
had already become firmly established by that time, the term "tax
benefit rule" appears to have originated and to have been first
applied in the context of the exclusionary principles ratified by the
enactment of Section 22(b)(12), and the courts have, on occasion,
continued to use the term solely in that context.  See, e.g., Alice
Phelan Sullivan Corp. v. United States, 381 F.2d 399, 401-402 (Ct. Cl.
1967).  In recent years, however, the term has come to be used to
encompass both the exclusionary principle and the inclusionary
principle that it presupposes.  See, e.g., Nash v. United States, 398
U.S. 1, 3 (1970);  Home Mutual Insurance Co. v. Commissioner, 639 F.2d
333, 343 (7th Cir. 1980), cert. denied, 451 U.S. 1017 (1981);  Anders
v. United States, 462 F.2d 1147, 1149 (Ct. Cl.), cert. denied, 409
U.S. 1064 (1972);  1 B. Bittker, supra, Paragraph 5.7.1.

   It is in this broader sense that the term "tax benefit rule" is
used in the present cases, which involve applications of the
inclusionary aspect of the rule in different factual contexts.  While
neither Section 22(b)(12) nor its successor, Section 111 of the 1954
Code, expressly codified the "inclusionary" aspect of the rule, this
enactment necessarily signals Congress' approval of the "inclusionary"
principles applicable here.  See Continental Illinois National Bank &
Trust Co. v. Commissioner, 69 T.C. 357, 370 (1977);  1 B. Bittker,
supra, Paragraph 5.7.1, at 5-49.  /12/

   2.  The inclusionary aspect of the tax benefit rule requires the
restoration to income of a prior year's deduction when subsequent
events establish the invalidity of the factual premise on which the
prior year's deduction was claimed.  What is at issue in the present
cases is whether the application of the tax benefit rule depends upon
the actual physical recovery of money or property by the taxpayer, or
whether the rule also requires restoration to income of a previously
deducted expense when subsequent events eliminate the factual premise
on which the deduction was originally claimed.

   We submit that the latter proposition is the correct rule.  In
Hillsboro Bank, the pertinent event was the judicial determination
that the previously deducted state tax was not due and owing and the
refund of those tax payments to the Bank's shareholders.  Likewise, in
Bliss Dairy, the relevant event was the liquidation of the corporation
and its distribution of unconsumed cattle feed to its shareholders,
thereby establishing that the cattle feed would not be consumed in its
business.  If a state tax turns out not to be due, there is no basis
for continued enjoyment of a deduction premised on its payment and the
bank must restore the deduction to income.  And if cattle feed will
not be used in a corporation's business, that corporation must restore
the deduction to its income when the fact of non-comsumption by the
corporation becomes established.  In sum, the subsequent events in
both cases demonstrate that the taxpayers did not incur the expense
for which they previously claimed the deductions.

   3. Perhaps the most common application of the tax benefit rule
arises in the context of the deduction for state income taxes
permitted by Section 164 of the Code.  Suppose A, a salaried employee
who reports his income on the cash basis method of accounting, has
$2,000 of state income taxes withheld from his salary during 1980.
When he files his 1980 state income tax return on April 15, 1981, he
discovers that his state tax liability is only $1,500, so that he is
entitled to a $500 refund, which the state department of revenue pays
to him in June 1981.  As a cash basis taxpayer, A is entitled to claim
the $2,000 in taxes as an itemized deduction on his 1980 federal
return, since that amount was fully paid by withholding during 1980.
However, because the deduction produced a tax benefit in 1980, A must
include the $500 refund in his 1981 federal taxable income.  Indeed,
the frequency of this situation has led the Internal Revenue Service
to add a line entitled "Refunds of state and local income taxes" (Line
9) on the Form 1040 individual income tax return so as to increase
compliance with the tax benefit rule.

   The parties would apparently agree that the foregoing example
offers an appropriate case for the application of the rule.  They
disagree, however, as to the critical element upon which the tax
benefit rule rests.  The taxpayers in these cases urge that the sine
qua non for the application of the rule is the actual recovery of
money or property, i.e., the receipt of the state tax refund.  In
Hillsboro Bank, the taxpayer asserts that the payment of the tax
refunds to its shareholders (rather than to itself) renders the tax
benefit rule inapplicable.  In Bliss Dairy, the taxpayer claims that
it never received any recovery warranting application of the rule.

   But surely the actual receipt of the tax refund is not the critical
element necessary to support the application of the tax benefit rule.
Returning to our example, if A had claimed the standard deduction in
1980 or had a tax loss for that year without taking the state tax
deduction into account, his actual receipt of the $500 state tax
refund would not have been includable in his 1981 gross income.
Conversely, if A had claimed an itemized deduction for the state taxes
and therefore enjoyed a tax benefit on his 1980 return, but the state
required him to credit the $500 refund to his (or his wife's separate)
1981 state tax liability, the tax benefit rule would nevertheless
require the inclusion of the $500 refund in his 1981 federal gross
income.  Properly analyzed, the $500 refund would have been deemed to
have been paid to A, who then would be deemed to have paid it either
back over to the state, or to his wife, who then would have been
deemed to have paid it back to the state.  In the same manner,
Hillsboro Bank must be deemed to have received back the tax refund and
paid it over to its shareholders.  Hence, actual receipt or recovery
of the money or property disbursed in connection with the prior year's
deduction is not a requirement of the tax benefit rule.

   We submit that there are two essential elements for the application
of the inclusionary aspect of the tax benefit rule at issue in these
cases.  First, the prior year's deduction must produce a tax savings
or benefit.  That element is indisputably present in both of these
cases.  Both Hillsboro Bank and Bliss Dairy enjoyed a tax benefit from
their deductions of state taxes and cattle feed purchases.  Second, an
event must occur in the tax year at issue which eliminates the factual
premise upon which the deduction was originally claimed.  This event
could well take the form of an actual recovery of money or property,
as in the first variation of our example.  The $500 tax refund to the
taxpayer removes the factual premise upon which the $2,000 deduction
for taxes was based and requires a corrective adjustment of $500 for
the year that the refund was paid.  But the event that removes the
factual premise of the prior deduction (in part or in whole) need not
take the form of an actual physical recovery of money or property.  It
could, as we suggest, take the form of a required issuance of a $500
credit to A's (or his wife's) 1981 state tax liability.  The factual
premise underlying the original deduction would nevertheless be
refuted, requiring restoration of the prior year's deduction into
income.

   There are many other instances in which the subsequent event that
undermines the foundation of the prior year's deduction and triggers
the application of the tax benefit rule does not involve any recovery
at all.  In our view, the triggering event can be any after-arising
circumstance that demonstrates the invalidity of the factual premise
on which the prior deduction was originally claimed.  It is this
so-called "inconsistent event" that lies at the heart of the tax
benefit rule and requires a corrective adjustment to set matters
right.  If, for example, the events at issue here had occurred during
the self-same prior year in which the deductions were taken, there is
no doubt that neither Hillsboro Bank or Bliss Dairy would have been
entitled to claim their deductions for state taxes and cattle feed.
When such "inconsistent" events occur in a subsequent taxable year,
they remove the factual premise of the prior year's deductions.  The
tax benefit rule thereby requires restoration of those deductions to
income.

 B. The Courts Developed The Tax Benefit Rule In Order to Offset The
Benefit Of A Deduction For Expenses Or Losses Which Subsequent Events
Establish Will Not Be Incurred

   1. The earliest origins of the principles underlying the tax
benefit rule are found in the Treasury Regulations under the Revenue
Act of 1913.  Treasury Regulations 33, Art. 125(1914) required the
inclusion in income of collection on debts for which bad debt
deductions had previously been taken.  That regulation itself assumed
an actual receipt of the previously deducted amount.  But such a
recovery, standing alone, would not be includable in the taxpayer's
gross income insofar as the repayment of a loan is not ordinarily
"income" within the meaning of the Sixteenth Amendment or the taxing
statute.  See Alice Phelan Sullivan Corp. v. United States, supra, 831
F.2d at 401;  1 B. Bittker, supra, Paragraph 5.7.1 Rather, the
recovery was simply an occasion for requiring a restoration to income
of a previously deducted amount based on the fact that retention of
the "tax benefit" generated by that deduction could no longer be
justified.

   The early case law makes much the same point in extending the tax
benefit rule to the repayment of any amount for which a tax loss had
previously been claimed.  For example, in South Dakota Concrete
Products Co. v. Commissioner, 26 B.T.A. 1429 (1932), the Board of Tax
Appeals applied tax benefit principles to the recovery of embezzled
amounts for which a loss deduction had been taken in a prior year,
explaining that the basic justification for the rule was the necessity
of accurately reflecting the taxpayer's income over a multi-year
period.  As the Board stated (26 B.T.A. at 1431):  "The Commissioner
has added no more to income than has been deducted previously, thus
bringing the amount of income reported over the period in balance with
the actual income of the taxpayer for this period." The Board noted
that the original deductions were simply "practical necessities due to
our inability to read the future, and the inclusion of the recovery in
income is necessary to offset the deduction" (id. at 1432).  /13/

   While the facts of South Dakota Concrete involved an actual
recovery, the "balancing entry" theory adopted by the Board was not
limited to the particular circumstances of that case.  On the
contrary, as the Board there indicated, the theory would apply
whenever "an adjustment occurs which is inconsistent with what has
been done in the past in the determination of tax liability" (26
B.T.A. at 1432).  That such an "adjustment" might be required in a
case involving other than an "actual recovery' is illustrated by the
Board's subsequent decision in Barnett v. Commissioner, 39 B.T.A. 864
(1939).  There, the Board upheld Treasury Regulations that required
the taxpayer to restore to income a previously claimed depletion
deduction taken in anticipation of exhaustion of her property's oil
reserve when the lease she had granted to an oil company expired
without any production ever having taken place.  This Court
subsequently reached the same result.  /14/ The significance of
Barnett and its progeny is that the Board relied on the tax benefit
principle as authority for the Regulation.  Thus, the Board reaffirmed
its balancing entry theory advanced in South Dakota Concrete that the
taxpayer had to recognize income in the current year not because she
had actually received anything that might be characterized as income
in the current year -- for she plainly had not -- but because income
recognition was necessary to balance out the prior deduction that was
allowed in anticipation of events that did not ultimately occur.  As
the Board noted (39 B.T.A. at 867) (emphasis added):

         (T)he present case is analogous to a number of others, where,
      with or without a supporting regulation, an adjustment has been
      made during the taxable year in which actually no income was
      received.  * * * Income tax liability must be determined for
      annual periods on the basis of facts as they existed in each
      period.  When some event occurs which is inconsistent with a
      deduction taken in a prior year, adjustment may have to be made
      by reporting a balancing item in income for the year in which
      the change occurs.

   Accord:  G.M. Standifer Construction Corp. v. Commissioner, 30
B.T.A. 184 (1934), appeal dismissed, 78 F.2d 285 (9th Cir. 1935).
/15/

   These early cases demonstrate that the application of the evolving
principles that were ultimately comprehended as part of a broader "tax
benefit rule" did not turn upon the identification and taxation of
economic benefits that could be considered as actual current income.
Rather, the courts recognized that the tax benefit rule was a remedial
device designed to insure that a taxpayer's income over a period
encompassing several taxable years would be accurately reflected where
subsequent events establish that no loss or expenses will actually be
incurred.  Simply put, the tax benefit rule is a mechanism for putting
right the imbalance caused by a previously claimed deduction that
subsequent events prove to have exceeded the expense or loss actually
incurred.  /16/

   2. To be sure, there have been more elaborate rationales suggested
for the tax benefit rule.  For example, in National Bank of Commerce
v. Commissioner, 115 F.2d 875, 876-877 (9th Cir. 1940), the court
suggested that the underlying theoretical basis of the tax benefit
rule is that when a taxpayer takes a deduction, he is constructively
recouping his capital investment, so that any further amounts received
with respect to the deducted item lose their nature as returns of
capital and take on, instead, the characteristics of the original
income that had been offset by the deduction.  /17/

   In Philadelphia National Bank v. Rothensies, 43 F. Supp. 923, 925
(E.D. Pa. 1942), the court characterized the rule in terms of waiver
or estoppel.  As it explained, a taxpayer who has claimed a deduction
is presumed to have consented to the recovery of the deduction should
it later turn out that the deducted amount exceeded his actual cost or
loss.  See also Commissioner v. First State Bank, 168 F.2d 1004 (5th
Cir.), cert. denied, 335 U.S. 867 (1948), where the court held that a
bank that distributed notes to its shareholders, after having
previously charged off the notes as worthless, was chargeable with
additional income when the shareholders later made collections on the
notes.  While the majority opinion rested this result on assignment of
income principles (168 F.2d at 1010), the concurring opinion of Judge
Sibley (speaking for himself and two of the other five judges) further
indicated that the bank had assumed both "the legal and the moral
duty" to restore future recoveries to income when it claimed the
deductions and that it could not free itself of that obligation simply
by transferring the uncollected notes to its shareholders (168 F.2d at
1011).

   The common thread linking the judicial and scholarly theories
addressing the basis of the tax benefit rule is that they all
recognize that the "recovery" or other event triggering the
application of the tax benefit rule does not, of itself, constitute
taxable income in the current year.  Rather, income is recognized in
the current year only because events of the current year have
demonstrated the invalidity of the assumptions underlying a previously
claimed deduction that served to reduce taxable income for a prior
year.  As Professor Bittker states in his authoritative treatise:

         While divergent, these theories share the view that the
      recoveries do not constitute economic gain in the ordinary sense
      and that their inclusion in income is an anomaly requiring
      explanation.  The premise, evidently, is that a creditor's
      collection of a just debt does not increase his net worth, even
      if he previously concluded that the debtor would never pay, and
      that a homeowner would not ordinarily think that partial refund
      of his local property tax, following recomputation of his
      liability in the light of hindsight, was an income-producing
      event.  Thus, the taxpayers in these cases are treated as
      realizing income only because they deducted amounts that, it now
      appears, exceeded their actual loss or cost.

   1 B. Bittker, supra, Paragraph 5.7.1, at 5-47 to 5-48 (emphasis
added).

   Since the basis of the tax benefit rule is the need to correct the
income distortion caused by a taxpayer's having claimed a deduction
for an expense or loss which, in the light of hindsight, exceeded his
actual expense or loss, it follows that the rule should apply on the
occurrence of any event that refutes the correctness of the factual
assumptions underlying a previously claimed deduction.  An actual
recovery of money or property is "simply the usual manifestation of an
'inconsistent event,'" Byrne, The Tax Benefit Rule as Applied to
Corporate Liquidations and Contributions to Capital:  Recent
Developments, 56 Notre Dame Law. 215, 232 (1980) (emphasis added).  It
is not, however, the only type of inconsistent event that triggers the
application of the rule.  /18/

   3. Nash v. United States, 398 U.S. 1 (1970), upon which petitioner
Hillsboro Bank relies (H. Br. 16-17), is not to the contrary.  There,
a partnership that had previously established a bad debt reserve and
had taken the appropriate deductions for additions to that reserve,
transferred all of its assets (including its accounts receivable) to a
newly formed corporation in exchange for that corporation's stock,
pursuant to Section 351 of the Code.  The parties agreed that at the
time of the transfer, the amount of the bad debt reserve was
reasonable so that the value of the stock received upon the transfer
was equal to the net value of the receivables.  On these facts, the
Court rejected the Commissioner's argument that the reserve should be
restored to the partnership's income because it was no longer needed
in its business.  Rather, the Court held that the tax benefit rule did
not require the partnership to restore the reserve to income because
the partnership received no gain as a result of the transaction.  As
it observed, "(w) edo not, however, understand how there can be a
'recovery' of the benefit of the bad debt reserve when the receivables
are transferred less the reserve.  That merely perpetuates the status
quo and does not tinker with it for any double benefit out of the bad
debt reserve" (398 U.S. at 5;  footnote omitted).

   The particularized circumstances of Nash do not cast doubt upon the
"inconsistent event" formulation of the tax benefit rule to which we
subscribe.  The factual premises underlying the deductions that were
taken by the partnership in establishing and maintaining the reserve
were in no way contradicted by the partnership's transfer of those
receivables to the corporation under Section 351.  /19/ The
transaction therefore was not an event that was inconsistent with the
claim of those prior deductions.  Since the partnership's basis in the
receivables was identical to their fair market value at the time of
the transfer and the corporation took that basis, there was neither
gain to the partnership nor the potential for any double tax benefit.
/20/

   Here, on the other hand, as we shall point out in greater detail,
the State's refund of the taxes previously deducted by petitioner
Hillsboro Bank, and the distribution to Bliss Dairy's shareholders of
cattle feed that had previously been "expensed" by that corporation,
are events that establish the invalidity of, and are therefore
inconsistent with, the factual assumptions on the basis of which
Hillsboro and Bliss previously claimed their deductions.  Hillsboro
Bank obtained the benefit of a deduction for a "tax" liability that
was not ultimately incurred;  Bliss Dairy enjoyed an "expense"
deduction for materials that were not ultimately used in its business
and that, thus, remained available as valuable assets for sale or
distribution to shareholders.  Absent the application of the tax
benefit rule requiring the restoration of deduction of taxes to
Hillsboro Bank's income upon the refund of the taxes to its
shareholders, the Bank would obtain the anomalous result of obtaining
a deduction for a dividend distribution to its shareholders.
Moreover, since the transferee-shareholders in Bliss Dairy took the
feed from their corporation at a "stepped-up" basis, they were able to
claim further deductions with respect to that same item when they used
the feed in their individually owned business.  Accordingly, unlike
the situation in Nash, the application of the tax benefit rule in
these cases forecloses an improper deduction for the payment of
dividends and a double tax benefit for the same item of expense.
Hence, "Nash simply does not stand for the proposition, for which it
is cited by taxpayer, that the tax benefit rule only applies in the
case of an actual physical, as opposed to 'fictional,' recovery of a
previously deducted amount." Tennessee-Carolina Transportation, Inc.
v. Commissioner, 582 F.2d 378, 383 (6th Cir. 1978), cert. denied, 440
U.S. 909 (1979).  See also Rev. Rul. 78-278, 1978-2 Cum. Bull. 134;
Byrne, The Tax Benefit Rule as Applied to Corporate Liquidations and
Contributions to Capital:  Recent Developments, supra, at 232-233.

                                  II

 THE PERSONAL PROPERTY TAXES PREVIOUSLY DEDUCTED BY HILLSBORO BANK
SHOULD BE RESTORED TO INCOME WHEN THE AMOUNTS IT PAID INTO ESCROW WERE
REFUNDED TO ITS SHAREHOLDERS ON WHOSE BEHALF THEY HAD BEEN DEPOSITED

   1. Ordinarily, where a corporation satisfies an obligation owing by
its shareholders, the corporation is not entitled to claim the benefit
of a deduction with respect to the payment.  If the corporation
nevertheless discharges its shareholders' obligations, the effect is
that of a dividend distribution so that the shareholders themselves
are charged with the receipt of dividend income to the extent their
own obligations are satisfied.  See, e.g., Wall v. United States, 164
F.2d 462, 464 (4th Cir. 1947).  Cf. Old Colony Trust Co. v.
Commissioner, 279 U.S. 716, 729 (1929).  As early as 1921, however,
Congress enacted special provisions allowing corporations to claim
deductions for the unreimbursed payment of personal property taxes
imposed on a shareholder's interest in the corporation.  Revenue Act
of 1921, ch. 136, Section 234(a)(3), 42 Stat. 254.  These special
provisions, allowing the corporation (rather than the shareholder) to
claim a deduction for such taxes, have been carried over into
successive revenue statutes and are now incorporated in Section 164(e)
of the 1954 Code.

   Under this Court's decision in United States v. Consolidated Edison
Co., 366 U.S. 380 (1961), however, deductions for payments of
contested liabilities (such as the personal property taxes paid by
Hillsboro Bank) would have been required to be deferred, in the case
of accrual basis taxpayers, until such time as the liability had been
finally resolved.  In response to that decision, Congress enacted
Section 461(f) of the Code, which allows a deduction for contested
liabilities where "the taxpayer transfers money or other property to
provide for the satisfaction of the asserted liability" and the
deduction would otherwise be allowable.  In support of this proposed
change, the Senate Committee Report indicated that "allowing the
deduction of items in the year paid * * * more realistically matches
these deductions up with the income to which they relate than would
the postponement of the deduction, perhaps for several years, until
the contest is settled." S. Rep. No. 830, 88th Cong., 2d Sess. 100
(1964).  The Committee also explicitly indicated, however, its
understanding that the tax benefit rule would operate to offset any
deduction for an expense that proved not to have been incurred.  It
therefore stated that "(t)o the extent that deductions are allowed
under this rule and then subsequently, as a result of the contest, the
items were found not to be payable, adjustment can be made for this
overstatement of the deduction by the inclusion of the overstatement
in income in the year in which the amount of the liability is finally
determined" (ibid.).

   Accordingly, Hillsboro Bank was unquestionably entitled, under
Sections 164(e) and 461(f), to deduct the amounts placed in escrow for
payment of the contested Illinois personal property taxes in the year
that payment was made.  See Treas. Reg. Section 1.461-2(c)(1) and
(c)(2), Example (2) (26 C.F.R.).  But once it was determined in the
following year that the Illinois constitutional provision at issue in
this Court's decision in Lehnhausen v. Lake Shore Auto Parts Co., 410
U.S. 356 (1973), was valid and that the personal property taxes paid
on behalf of individual shareholders were not owing, a restoration to
Hillsboro Bank's income of the previously deducted amount was
required, despite the fortuitous fact that the refund was directed to
the shareholders on whose behalf the tax had been paid rather than to
the Bank itself.

   The refund of the amounts previously paid on behalf of the Bank's
shareholders for satisfaction of the personal property tax liability
that might ultimately have been determined to be owing undermines the
factual premise upon which the Bank previously deducted such amounts
pursuant to Sections 164(e) and 461(f) of the Code.  As we have noted
(page 31, supra), Congress specifically intended that any
"overstatement of the deduction" would be restored to income in the
event that the contested liability is "finally determined." S. Rep.
No. 830, supra, at 100.  That refund in this case was paid directly to
the shareholders on whose behalf the amounts were deposited in the
escrow account pursuant to Ill. Ann. Stat. ch. 120, Section 676.01
(Smith-Hurd Cum. Supp. 1981), rather than to the Bank alone, or to the
Bank and its shareholders jointly, is not a sufficient basis for
allowing the Bank to retain the benefit of its prior deduction.
Regardless of who is ultimately entitled to receive the refunded
amount, the determination of nonliability and the consequent tax
refund (whether to the Bank or to its shareholders) are inconsistent
with the allowance of a deduction to any party under Section 164.
While amounts were deposited for satisfaction of an asserted liability
and, as a result, properly deducted at that time, no tax liability
was, in fact, ever incurred by the Bank or its shareholders.  Instead,
what ultimately occurred was that the corporate funds that were
originally deposited by the Bank for this purpose were diverted, via
the escrow deposit, to its shareholders.

   Indeed, as the court below recognized both in this case (H. Pet.
App. A-8) and previously in the virtually identical situation in First
Trust (614 F.2d at 1147), /21/ the ultimate result in each case was to
transform the escrow deposit into a dividend from the Bank to its
shareholders.  For, absent the special treatment allowed under Section
164(e), the payment of these taxes on behalf of the shareholders would
have been treated as a dividend in the first instance.  But the
justification under those provisions for avoiding dividend treatment
at that time (see Treas. Reg. Section 1.164-7 (26 C.F.R.)) entirely
disappeared when the taxes were determined not to be owing and the
amounts previously paid on the shareholders' behalf were distributed
to those same shareholders.  Thus, unless the tax benefit rule applies
to restore the erroneous deduction to Hillsboro Bank's income, the
Bank will have obtained the benefit of a wholly improper tax deduction
for what was in the end no more than a dividend distribution to its
shareholders.  The corrective tax benefit rule is designed to prevent
such an anomaly.  /22/

   2. The dissenting judge below argued that application of the tax
benefit rule would unjustifiably result in taxation of both the Bank
and its individual shareholders upon the amounts refunded to those
individuals (H. Pet. App. A-14 to A-20).  It is, however, settled
beyond peradventure under federal tax law that corporate income
taxable to the corporation is, upon distribution as dividends, taxed
again at the shareholder level without a corresponding deduction to
the corporation.  As the Seventh Circuit earlier stated in First Trust
(614 F.2d at 1147):

      But, of course, the distributed refunds were corporate
      dividends, taxable to the stockholders when received, but,
      nevertheless, nondeductible expenses to the Bank under our
      familiar system of "double taxation" at both the corporation and
      shareholder level.  I.R.C. Sections 316, 301.  Thus, unless the
      deduction previously taken is reversed (by taxing the amount of
      the refund), the Bank will, in effect, have benefited from a
      deduction taken for a nondeductible distribution.

   Nor is there any unfairness in this result.  Hillsboro presumably
knew, from the outset, that the taxes in question were being contested
and would not be owing in the event the validity of Illinois
constitutional provisions in issue was sustained by this Court.  It
was also presumably aware of the possibility that payments it had made
on behalf of its shareholders would be refunded, in the event that
liability were set aside, to the shareholders themselves.  /23/ That
liability, moreover, was solely that of the shareholders and not that
of the Bank itself.  While it was customary for Illinois banks to pay
such taxes on behalf of their shareholders, the statute required only
that the bank retain so much of any dividends that it might distribute
to shareholders as would be necessary to pay the taxes levied against
their shares.  Ill Ann. Stat. ch. 120, Section 558 (Smith-Hurd 1970).
See, e.g., People v. First National Bank, 33 Ill. 2d 457, 211 N.E.2d
713 (1965);  People v. Oak Park Trust & Savings Bank, 351 Ill. 334,
184 N.E. 643 (1933);  People v. Toluca State Bank, 327 Ill. 638, 159
N.E. 240 (1927).  /24/ Having chosen to use corporate funds to satisfy
the personal obligations of the shareholders, Hillsboro can hardly
complain that dividend treatment is unwarranted when the funds
themselves were paid over to those same shareholders.  While a
deduction was proper for the year 1972 based on the circumstances
existing as of the end of that year, it was clear, by the next year,
that the tax liability on which that deduction was based did not
exist.  Restoration to income of the amount that escaped tax in 1972
was thus no less appropriate in these circumstances than would be the
case if the escrow payments had been returned directly to the Bank for
its own determination as to whether such amounts should then be
distributed to the shareholders or reinvested on their behalf.

   3. Hillsboro rests virtually its entire argument on the premise
that the tax benefit rule requires the receipt by the taxpayer of an
actual economic benefit in the year in question.  But, as we have
pointed out (pages 21-30, supra), that is not the basis of the rule.
Even where there is an actual recovery, there would be no occasion for
charging the taxpayer, on that ground alone, with the realization of
additional gross income.  Rather, what is required is the restoration
to taxable income of the taxpayer's prior income that escaped tax in
earlier periods solely as a result of deductions that were proper when
claimed, but which were based on anticipated losses or expenses that
subsequent events establish will not be incurred.  /25/ The fact that
the liability for the Illinois personal property tax in question was
not resolved until after the deduction was claimed in 1972 resulted,
as the court below concluded (H. Pet. App. A-8), in a significant
"windfall" to the Bank in the form of avoiding federal income tax
liability on the income offset by that deduction.  Had Section 461(f)
not been enacted, such contested liabilities would not have been
deductible in the first instance.  That statute enabled the Bank to
claim a deduction in 1972.  At the same time, the Bank's claim of a
deduction for a contested liability necessarily gave rise to the
possibility that the income that thereby escaped taxation would have
to be restored in the later period in which the disputed liability was
finally resolved.

   What is more, the application of the tax benefit rule in these
circumstances is not -- as Hillsboro would have it (H. Br. 19-20) --
dependent upon either assignment-of-income or constructive receipt
theories.  The judicial development of the tax benefit rule shows that
it arises from the need to offset the distortion resulting from the
taking of a deduction of an anticipated expense or loss that is not
ultimately incurred.  The motives, perceptions and conduct of the
taxpayer involved are irrelevant.  Accordingly, Hillsboro's arguments
(H. Br. 21-22) that it did not engage in collusion with the County
Treasurer's office regarding the recipients of the tax refunds in no
way affects application of the tax benefit rule.

   Finally, even if some form of recovery is deemed to be necessary to
invoke the tax benefit rule, we submit that the Bank should be deemed
to have at least constructively recovered the refunded taxes.  Indeed,
that is precisely what the Tax Court determined in this case.  It
stated that "When in 1973 (Section 164(e)) was retroactively
determined not to apply, and the taxes paid were refunded to these
same shareholders, (the Bank) must be deemed to have received back its
payments from the state and itself paid these amounts out to its
shareholders" (H. Pet. App. A-39).

                                  III

 THE AMOUNTS PREVIOUSLY DEDUCTED BY BLISS DAIRY THAT ARE ATTRIBUTABLE
TO CATTLE FEED UNCONSUMED IN ITS BUSINESS AND DISTRIBUTED TO ITS
SHAREHOLDERS ON LIQUIDATION SHOULD BE RESTORED TO ITS TAXABLE INCOME
FOR ITS YEAR OF LIQUIDATION

 A. A Corporation's Distribution Of Previously Deducted Cattle Feed To
Its Shareholders Refutes The Assumptions Underlying The Corporation's
Claim To Deductions For The Cost Of That Feed

   1.  On its return for the taxable year ending June 30, 1973,
respondent Bliss Dairy deducted the full cost of the $150,199 worth of
cattle feed that it had purchased in that year.  This deduction was
based on the assumption that, even though income might be more
accurately reflected through the use of inventory accounting for such
supplies, the feed would ordinarily be consumed within a relatively
short time in the course of the taxpayer's operation of the business.
See Spitalny v. United States, 430 F.2d 195, 197 (9th Cir. 1970);
Rev. Rul. 79-229, 1979-2 Cum. Bull. 210.  Cf. United States v. Catto,
384 U.S. 102 (1966).  However, only $93,634 of the feed was consumed
in the year for which the deduction was claimed.  On the second day of
the next taxable year, Bliss adopted a plan of liquidation and, within
the month, distributed the remaining $56,565 worth of previously
expensed feed to its shareholders.  This in kind of distribution of
unconsumed feed eliminated the basis for the original assumption
underlying Bliss' deduction that the feed would be consumed in the
ordinary course of Bliss' business.  If Bliss Dairy had permitted the
feed to be used for the personally-owned cattle of its shareholders
there would be no question that its deduction for that feed would have
to be restored to income.  Accordingly, Bliss' liquidating transfer of
the feed was likewise an appropriate event for applying the tax
benefit rule so as to require a restoration of the amount deducted in
the prior year for the distributed feed.  /26/

   There are, to be sure, instances in which a transfer of previously
"expensed" property would not be inconsistent with the deduction and
in which the restoration to income of the previously deducted amount
would not be warranted.  For example, where property is transferred to
a successor corporation pursuant to a corporate reorganization within
the scope of Section 368(a)(1) of the Code or to a parent corporation
on the liquidation of a subsidiary under Section 332 of the Code
(other than a liquidation to which Section 334(b)(2) applies), the
property remains in corporate solution and the transaction is
generally treated, for federal income tax purposes, as "work(ing) a
change of form rather than of substance." B. Bittker & J. Eustice,
Federal Income Taxation of Corporations and Shareholders Paragraph
11.40, at 11-31;  Paragraph 14.01, at 14-6 (4th ed. 1979).  In either
of these cases, the transferee corporation takes the property subject
to the same basis that it had in the hands of the transferor -- zero,
of course, in the case of property that had already been fully
"expensed" at the time of the transfer.  See Sections 334(b)(1) and
362(b).  See also B. Bittker & J. Eustice, supra, Paragraph 11.44, at
11-41 and 11-42;  Paragraph 14.33, at 14-108 and 14-109.  For example,
if the unconsumed cattle feed had been transferred to a parent
corporation or to a successor corporation in a qualifying
reorganization, its zero basis would have carried over to the
transferee and no further deduction would have been taken.  /27/ In
these special circumstances, the transferee is deemed to have stepped
into the shoes of the transferor.

   A substantially different situation is presented, however, when
fully "expensed" property is transferred out of corporate solution, as
in the instant case, or to another corporation in a transaction that
is not treated, for tax purposes, as simply working a change of form.
See Tennessee-Carolina Transportation, Inc. v. Commissioner, supra.
In these cases, the zero (or other) basis of the property in the hands
of the transferor does not carry over to the transferee in such
instances.  For example, where the stock of a liquidating corporation
is acquired by a corporation pursuant to a transaction qualifying
under Section 334(b)(2) of the Code, the transferee is treated as a
purchaser of the underlying assets and is accordingly entitled to
allocate the cost of acquiring the stock among all the assets acquired
(including previously "expensed" items).  See e.g., Kimbell-Diamond
Milling Co. v Commissioner, 14 T.C. 74 (1950), aff'd, 187 F.2d 718
(5th Cir.), cert. denied, 342 U.S. 827 (1951);  Kansas Sand &
Concrete, Inc. v. Commissioner, 462 F.2d 805 (10th Cir. 1972);  In re
Chrome Plate, 614 F.2d 990 (5th Cir. 1980).  B. Bittker & J. Eustice,
supra, Paragraph 11.44, at 11-42 through 11-48.  Other shareholders
who receive in-kind liquidating distributions ordinarily take the
property at a basis equal to its fair market value on the date of
distribution.  Section 334(a);  B. Bittker & J. Eustice, supra,
Paragraph 11.04.

   Finally, where, as here, a corporation is liquidated pursuant to
the elective provisions of Section 333, /28/ the shareholder's basis
in his stock (reduced by any money received and increased by any gain
recognized on the transaction) is likewise allocated among the assets
acquired in accordance with their relative fair market values.
Section 334(c) of the Code;  Treas. Req.  Section 1.334.2 (26 C.F.R.).
 See generally B. Bittker & J. Eustice, supra, Paragraph 11.22.
Although the basis of distributed assets may vary depending on whether
Section 334(a), 334(b)(2) or 334(c) applies, in each instance the
"expensed" items do not retain the "zero" basis they had in the hands
of the transferor, but acquire an appropriately "stepped-up" /29/
basis in the hands of the transferees enabling them, as in Bliss
Dairy, to claim a further deduction when the items are actually
consumed in the course of their separate businesses, or to avoid the
recognition of gain in the event they choose to sell the previously
expensed materials to third parties.

   Thus, the result in cases involving liquidations, such as Bliss
Dairy, is not simply to shift income temporarily from one period to
another, but to leave the transferor (unless the tax benefit rule is
applied) with the permanent "tax benefit" of an "expense" deduction
for the cost of items that were not, in fact, consumed, and never will
be consumed, in its own trade or business.  Moreover, shareholders
will be able to claim a further deduction for the same item.  As this
Court has admonished, " * * * the Code should not be interpreted to
allow * * * 'the practical equivalent of double deduction';  Charles
Ilfeld Co. v. Hernandez, 292 U.S. 62, 68 (1934), absent a clear
declaration of intent by Congress." United States v. Skelly Oil Co.,
supra, 394 U.S. at 684.  See also Marwais Steel Co. v. Commissioner,
354 F.2d 997 (9th Cir. 1965).

   Indeed, the case for the application of the tax benefit rule is
considerably strengthened by the fact that the facts present not
simply the "practical equivalent" of a double deduction but an actual
potential double deduction.  Here, the shareholders of Bliss Dairy,
who continued the dairy business in non-corporate form, took a
"stepped-up" basis /30/ in the cattle feed, and quite properly
deducted the amount of that basis when the feed was consumed in the
course of their business.  In a prior year, Bliss Dairy claimed a
similar deduction.  In these circumstances, the corporation must
restore to its own income that portion of the amount previously
deducted that was attributable to the feed that was not ultimately
used in its trade or business and that remained available for sale or
distribution to shareholders on the winding up of the corporation's
affairs.  /31/

   2. In holding that Bliss Dairy's tax benefit from its deduction for
cattle feed for use in its business and its subsequent distribution to
its shareholders of that feed did not require restoration of the
deduction to the corporation's income unless there was an actual
recovery by the corporation of money or additional property, the court
below relied exclusively on its prior decision in Commissioner v.
South Lake Farms, Inc., supra.  It quoted the following statement from
South Lake Farms (B. Pet. App. 4a):  "Nowhere in the Code do we find
an intent that gains to the stockholders were to be attributed to the
corporation, much less that they were to be treated as ordinary income
to the corporation" (324 F.2d at 839).  /32/

   The court below thus misunderstood why Bliss Dairy should be
required to recognize income in the current taxable year.  The
government is not seeking to attribute to Bliss the gains of its
shareholders.  Rather, it is Bliss' own ordinary income -- the income
that escaped tax in a prior taxable year as a result of the deduction
for cattle feed that would be consumed, if at all, only in subsequent
periods -- that the government seeks to restore to taxable income.
Once subsequent events made it clear that the anticipated events on
which the deduction was based -- that the feed would shortly be used
(and, thus, become an "expense") in the operation of the corporate
business -- would never occur, such a restoration to income is
required under the tax benefit rule.  Indeed, as the Ninth Circuit
itself recognized in a case decided subsequently to Bliss Dairy, the
recovery of a deduction is taxed under the tax benefit rule "because
it previously created a tax benefit, not because of the inherent
characteristic of the recovery." Unvert v. Commissioner, 656 F.2d 483,
486 (9th Cir. 1981), cert. denied, No. 81-1467 (May 2, 1982).

   Here, where Bliss Dairy indisputably took a deduction that offset
its ordinary income, and where that deduction was in an amount that,
as subsequent events showed, exceeded its actual cost of doing
business, the restoration of that deduction to income in its final
taxable period was necessary to offset the deduction that proved to be
excessive.  It is that necessity that gave rise to the tax benefit
rule, and calls for its application in this case.

 B. At All Events, Even If An "Actual Recovery" Is Required For The
Application Of The Tax Benefit Rule, Bliss Dairy Enjoyed Such A
Recovery

   Even if the tax benefit rule requires an actual recovery to trigger
its application, Bliss Dairy did enjoy the benefits of such a recovery
in this case.  As the Sixth Circuit noted in Tennessee-Carolina
Transportation, Inc. v. Commissioner, supra, 582 F.2d at 382, where
the cost of materials and supplies are "expensed," they are "in
contemplation of the tax laws, completely consumed." This deduction is
allowed and a zero basis assigned not because there has been an actual
loss or exhaustion of value, but on the "contemplation of their actual
consumption." As a result, they are treated, for tax purposes, as
having become a "nonentity" (ibid.).  Where, however, the
corporation's own activities are wound up before such actual
consumption takes place, the value of the property remains available
to the corporation and its shareholders, to be enjoyed either by the
sale of the property by the corporation or by distribution of the
unconsumed property to the shareholders for their own sale or use.  In
either case, there is a "recovery" of the value that had been
"fictionally" converted into an item of expense.  Such a "fictional
conversion" must, of course, be hypothesized to allow a current
"expense" deduction because an expenditure for the acquisition of
valuable assets "is capital in nature and not an expense, let alone an
ordinary expense * * * ." Commissioner v. Lincoln Savings & Loan
Association, 403 U.S. 345, 354 (1971).  The allowance of a current
expense deduction for items that will ordinarily not be consumed
within a short period is based on practical considerations.  Those
same practical considerations mandate that what is deemed to have been
consumed in the year of acquisition should be deemed recovered, as the
Sixth Circuit concluded in Tennessee-Carolina, when it is transferred
from a corporation to another party.

   Indeed, the Ninth Circuit itself recognized in Spitalny v. United
States, supra, 430 F.2d at 198, that there has been, in such
circumstances, a "fictional conversion of * * * 'property' into a
consumed item of expense" and that (ibid.) -- "(i)f the feed and
supplies are to revert to 'property' they should be reconverted.  They
should not at the same time be property and still retain attributes of
a fictional nonentity." See also Anders v. United States, supra, 462
F.2d at 1149.  In Spitalny, the liquidating corporation sold the
previously expensed, but unconsumed, cattle feed and other expensed
supplies there in question, and distributed the proceeds to the
shareholders.  Accord:  Tennessee-Carolina Transportation, Inc. v.
Commissioner, supra, 582 F.2d at 382.  As an economic matter, the
parties are in precisely the same position whether such expensed
property is sold by the corporation or distributed "in kind" to the
shareholders.  If a restoration to income of the previously deducted
amount is in order in the first instance (as virtually every court
that has considered the matter has concluded -- see page 42, note 31,
supra), such a restoration is likewise appropriate here.

   There is a second basis for attributing a "recovery" to the
liquidating corporation -- assuming such a "recovery" is essential.
The liquidation of a corporation is itself an "exchange" of property
-- i.e., a transfer by the shareholders of their shares to the
corporation, in exchange for a distribution by the corporation of its
assets.  See B. Bittker & J. Eustice, supra, Paragraph 11.01.  While
it is true that after the liquidation has been completed the shares
received by the corporation loses its value, such stock presumably had
the same value as the distributed assets themselves had at the time of
the transaction.  Tennessee-Carolina Transportation, Inc. v.
Commissioner, supra, 582 F.2d at 382.  Accordingly, at the time Bliss
Dairy received its shares back from its shareholders in the course of
the liquidation, that stock still had value reflecting, inter alia,
the $56,565 in unconsumed cattle feed remaining on hand.  /33/ Thus,
under the facts of this case, there was a "recovery" of the value of
the unconsumed cattle feed.  While it is true that the recovery was
transient, it was no less transient than the recovery would be on a
liquidation sale, as in Spitalny, where the proceeds are immediately
distributed to the shareholders in the course of liquidation.

   Ordinarily, the receipt of stock by the corporation in exchange for
the distribution of its assets on liquidation is not treated as a
taxable transaction to the corporation.  Section 336 provides that "no
gain or loss shall be recognized to a corporation on the distribution
of property in partial or complete liquidation." See B. Bittker & J.
Eustice, supra, Paragraph 11.61.  Thus, the value of appreciated
property distributed in kind to the shareholders is not treated as
having been realized by the corporation.  See United States v.
Cumberland Public Service Co., 338 U.S. 451 (1950).  But the
provisions of Section 336 should not be considered as having any
greater bearing on the application of the tax benefit rule in this
context than the analogous provisions of Section 337(a) of the Code,
providing that "no gain or loss shall be recognized to * * * (the)
corporation from the sale or exchange by it of property" pursuant to a
12-month liquidation plan qualifying under that Section.  As we have
pointed out (page 42, note 31, supra), the courts have uniformly
upheld the Commissioner's position in requiring the restoration of
prior deductions to income where previously expensed items are sold
pursuant to such Section 337 liquidations, despite the "no gain or
loss" language of that statute.  Those cases simply reflect the
established understanding of the function of the tax benefit rule as
requiring a restoration to income of a previously deducted amount,
even though there would be no occasion for charging the taxpayer with
additional income, absent the enjoyment of such a prior tax benefit.

   To construe Section 336 as precluding the application of the tax
benefit rule to a corporation that distributes previously expensed
property to its shareholders, notwithstanding its "recovery" of stock
having an equivalent value, would result in a wholly unjustified
disparity in the tax treatment of liquidations falling within Section
337 (where property is sold and the proceeds are distributed to the
shareholders) and liquidation distributions of property governed by
Section 336.  Indeed, it was the purpose of Section 337 to eliminate
such tax disparities based on whether property was sold by a
liquidating corporation (as in Commissioner v. Court holding Co., 324
U.S. 331 (1945)) or distributed to the shareholders (as in United
States v. Cumberland Public Service Co., supra).  See H.R. Rep. No.
1337, 83d Cong., 2d Sess. A 106 (1954);  S. Rep. No. 1622, 83d Cong.,
2d Sess. 258-259 (1954).  /34/

   Assume, for example, that a liquidating corporation is in
possession of $100,000 of previously expensed supplies.  It may choose
either (1) to sell such property for that amount and to distribute the
proceeds, or (2) to distribute the property directly to the
shareholders.  Those shareholders, in turn, might then sell the
property for the same amount or obtain the economically equivalent
benefit of using the property in their own trade or business, claiming
a "stepped-up" basis of the property (which will, as noted above,
ordinarily equal or approach its fair market value) so as to generate
further deductions from their own income.  In either case, the
economic positions of the parties are the same.

   There is accordingly no justification for treating the transactions
differently, particularly in light of the purpose of Section 337 to
eliminate disparities in the tax treatment of such transactions.  "(F)
rom a tax policy standpoint it does not make sense that in applying a
judicially created rule intended to avoid income distortions, results
should differ depending on whether a corporation liquidates by way of
Section 336 or 337." Byrne, The Tax Benefit Rule as Applied to
Corporate Liquidations and Contributions to Capital:  Recent
Developments, supra, 56 Notre Dame Law, at 232.  The courts are agreed
that there is no reason why the corporation should not be required to
restore the previously deducted amount to income when it sells the
property and distributes the proceeds pursuant to Section 337.  Yet,
pursuant to the decision of the court of appeals in the instant case
under Section 336, nothing is restored to income, and the tax savings
resulting from the prior deduction are passed on to the shareholders
despite the fact that the fully "expensed" property is distributed to
them with a stepped-up basis.  This is just the type of disparity that
Congress intended to end when it enacted Section 337 as part of the
Internal Revenue Code of 1954.  If that intent is to be fully
effectuated, liquidations under both Sections 336 and 337 should be
treated alike.  See Midland-Ross Corp. v. United States, 485 F.2d 110,
114 (6th Cir. 1973);  B. Bittker & J. Eustice, supra, Paragraph 11.65.
 Otherwise, the course set by the court below will "elevate form over
substance by reviving technical differentiations put to rest in 1954
with the adoption of Section 337." Tennessee-Carolina Transportation,
Inc. v. Commissioners, supra, 582 F.2d at 383 (footnote omitted).
/35/

                              CONCLUSION

   The judgment of the court of appeals in No. 81-485 should be
affirmed.  The judgment of the court of appeals in No. 81-930 should
be reversed.

   Respectfully submitted.

   REX E. LEE

      Solicitor General

   GLENN L. ARCHER, JR.

      Assistant Attorney General

   STUART A. SMITH

      Assistant to the Solicitor General

   GARY R. ALLEN

   JAY W. MILLER

   DAVID I. PINCUS

      Attorneys

   MAY 1982

   /1/ "H. Pet. App." references are to the appendix to the petition
in the Hillsboro National Bank case, and "B. Pet. App." references are
to the appendix to the petition in the Bliss Dairy case.  Pursuant to
the Court's order of March 1, 1982, no joint appendix has been filed
in these cases.

   /2/ Section 164(e) provides that where a corporation pays a tax
imposed on a shareholder on his interest as a shareholder and is not
reimbursed for such payment, the corporation (and not the shareholder)
is allowed the deduction for the tax provided for by Section 164(a).
Such payment is not then included in the shareholder's gross income.
Treas. Reg. Section 1.164-7 (26 C.F.R.).

   /3/ Under Section 333, shareholders receiving corporate assets
pursuant to a qualifying one-month liquidation are required to
recognize only so much of their gain as does not exceed the greater of
their pro rata share of the corporation's earnings and profits or the
amount of money and (post-1953) stock and securities received in the
liquidation.

   /4/ Under Section 334(c) of the Code, a shareholder's basis in
property acquired in a Section 333 liquidation is equal to the basis
he had in the liquidating corporation's stock, decreased by the amount
of money received in the liquidation, and increased by the amount of
any gain recognized.  Where several assets are received, the
shareholder apportions his total basis among these assets in
accordance with their relative fair market values.  Treas. Reg.
Section 1.334-2 (26 C.F.R.).  The record does not disclose the exact
amount of basis that the Bliss shareholders assigned to the unused
cattle feed distributed by the corporation.  However, the parties
stipulated in the district court that the shareholders, on their 1973
individual income tax returns, claimed deductions attributable to the
feed they received in the liquidation (see B. Pet. App. 3a).

   /5/ It was later stipulated that at the time of distribution, the
unconsumed feed had a value of $56,565 (B. Pet. App. 3a).

   /6/ See Tennessee-Carolina Transportation, Inc. v. Commissioner, 65
T.C. 440 (1975), aff'd, 582 F.2d 378 (6th Cir. 1978), cert. denied,
440 U.S. 909 (1979);  First Trust and Savings Bank v. United States,
614 F.2d 1142 (7th Cir. 1980);  Hillsboro National Bank v.
Commissioner, 641 F.2d 529 (7th Cir. 1981), cert. granted, No. 81-485
(Jan. 18, 1982).

   /7/ This Court subsequently reached the same result in Douglas v.
Commissioner, 322 U.S. 275, 284-287 (1944).

   /8/ Moreover, even if some form of recovery is deemed to be
necessary to invoke the tax benefit rule, we submit that the Bank
constructively recovered the refunded taxes.  Indeed, that is
precisely what the Tax Court determined in this case, stating that
"When in 1973 (Section 164(e)) was retroactively determined not to
apply, and the taxes paid were refunded to these same shareholders,
(the Bank) must be deemed to have received back its payments from the
State and itself paid these amounts out to its shareholders" (H. Pet.
App. A-39).

   /9/ At all events, even on the assumption that an "actual recovery"
is required to support an application of the tax benefit rule, Bliss
Dairy had all the benefits of such a recovery from its distribution of
the unconsumed cattle feed to its shareholders.  For tax purposes,
once the cost of materials are deducted, they are regarded as
completely consumed.  They are assigned a zero basis and are actually
treated nonexistent for tax purposes.  When, however, the value of the
property becomes available for distribution to shareholders for their
own sale or use, there is a "recovery" for tax purposes of the value
that had been previously converted into an item of expense.

   Second, Bliss Dairy's receipt of its stock certificates from its
shareholders in the course of its liquidation constituted a recovery
of the unconsumed cattle feed.  At the time Bliss Dairy received its
shares back from its shareholders in the course of liquidation, those
shares still had value reflecting the $56,565 in unconsumed cattle
feed remaining on hand.  Thus, there was a "recovery" of the value of
that feed.  Thus, an actual recovery occurred when Bliss Dairy
exchanged its assets for shares that had an equivalent value at the
time of the transfer.

   /10/ In United States v. Lewis, supra, the allowance of a
later-year deduction for the repayment of previously reported income
did not produce a tax benefit commensurate with the tax cost of
reporting the item of income in the first instance.  In response,
Congress added Section 1341 to the statute, as part of the 1954
codification, in order to achieve a closer correspondence between the
tax benefit of the later deduction and the tax cost of the earlier
inclusion.

   Section 1341 generally provides that if an item is included in
income under a claim of right in one year and becomes deductible in a
subsequent year because it was established that the taxpayer did not
have an unrestricted right to the item, and the amount of the
deduction exceeds $3,000, then the tax for the subsequent year is the
lesser of:  (a) the tax computed with the deduction;  or (b) the tax
for the taxable year computed without the deduction, minus the
decrease in tax for the prior taxable year that would result from the
exclusion of the item from gross income for the prior taxable year.
The statute therefore insures that the tax benefit obtained will be
the greater of the amount achieved either by deduction or exclusion.

   /11/ Section 111 thus performs a function that is somewhat
analogous (albeit with somewhat less precision) to Section 1341 in the
context of the "claim of right" doctrine (see page 15, note 10).  In
United States v. Skelly Oil Co., supra, where the special provisions
of Section 1341(a)(5) did not apply, the Court adopted an analogue to
this aspect of the tax benefit rule, holding that where the taxpayer
had enjoyed the benefit of a depletion allowance measured by a
percentage of previously reported income which it was thereafter
required to give up, the amount of the subsequent deduction under
North American Oil should be similarly reduced.  In so holding the
Court noted that the taxpayer would otherwise be allowed "'the
practical equivalent of a double deduction,'" a result the Court
concluded should not be permitted "absent a clear declaration of
intent by Congress" (394 U.S. at 684, quoting Charles Ilfeld Co. v.
Hernandez, 292 U.S. 62, 68 (1934)).

   /12/ Congress' approval of the "inclusionary" aspect of the tax
benefit rule is also implied by its enactment of Section 461(f) of the
Code, allowing the deduction of contested liabilities.  As we discuss
(pages 31-32, infra), Congress enacted this provision on the explicit
understanding that a restoration to income would be required if the
liability was ultimately set aside.  See S. Rep. No. 830, 88th Cong.,
2d Sess. 100 (1964).

   /13/ Cf. Home Mutual Insurance Co. v. Commissioner, 639 F.2d 333,
344 (7th Cir. 1980), cert. denied, 451 U.S. 1017 (1981) (explaining
that the tax benefit rule "allows accurate taxation of a whole
transaction that may span several accounting periods," and permits
"adjustments so that some transactions substantially altered in years
subsequent to the original accounting period may be taxed virtually as
though the entire transaction had occurred in one period").

   /14/ The requirement that oil depletion deductions be restored once
it is clear that no mineral production will actually take place was
approved in Sneed v. Commissioner, 119 F.2d 767 (5th Cir), cert.
denied, 314 U.S. 686 (1941), in Lamont v. Commissioner, 120 F.2d 996
(8th Cir. 1941), and, ultimately, in Douglas v. Commissioner, 322 U.S.
275, 284-287 (1944), which cited all three prior decisions with
approval.  As the Eighth Circuit noted in Lamont, such a restoration
does not "arbitrarily assume non-existent income" (120 F.2d at 997).
What is ultimately subjected to tax, as the court there emphasized, is
the real income that escaped tax when the original depletion allowance
was claimed.  Cf. United States v. Skelly Oil Co., supra, 394 U.S. at
684, which similarly required corrective adjustment where the income,
on which a depletion allowance was previously claimed, was required to
be refunded.

   /15/ There, the Board required the taxpayer, in the year of its
liquidation, to restore to income the amount of prior accrued
deductions for wages that remained unpaid at that time.  In holding
that prior deductions for what amounted to a "reserve" for unpaid
liabilities on a disputed claim should also have been restored to
income, but only in the prior year when the dispute was settled for a
lesser amount, the Board noted that "(t)he theory underlying the
restoration of reserve balances to income, like that of recoveries on
losses for prior years * * * and collections on debts previously
deducted as worthless * * * , is that by taking the deductions in the
earlier years the taxpayer benefited through a reduction of its
taxable income, and subsequent events demonstrate that there was in
fact no loss, even though honest belief so indicated at the time" (78
F.2d at 187).

   /16/ Legal scholars and commentators likewise agree that the
purpose of the tax benefit rule is to rectify the distortion caused by
a taxpayer's having taken a deduction to which, in the light of
hindsight, he would not be entitled.  See, e.g., Plumb, The Tax
Benefit Rule Today, 57 Harv. L. Rev. 129, 176 (1943) ("The rule
requiring taxation of income from the recovery or cancellation of
items previously deducted is a remedial expedient, designed to prevent
the unjust enrichment of a taxpayer and to offset the benefit derived
from a deduction to which, in the light of subsequent events, the
taxpayer was not entitled");  Byrne, The Tax Benefit Rule as Applied
to Corporate Liquidations and Contributions to Capital:  Recent
Developments, 56 Notre Dame Law. 215, 232 (1980) ("The tax benefit
rule has been designed by the courts as a tool for correcting the
distortion resulting from a taxpayer's taking a deduction which, in
the light of subsequent events, exceeds his loss or cost").  See also
Lyon & Eustice, Assignment of Income:  Fruit and Tree as Irrigated by
the P.G. Lake Case, 17 Tax L. Rev. 295, 411 (1962).

   /17/ The court in National Bank of Commerce appears to have adopted
this theory of "transubstantiation of capital into income" (1 B.
Bittker, supra, Paragraph 5.7.1, at 5-46) in order to avoid what it
perceived as the problem of imposing a tax in the absence of the
realization of "income." We would suggest, however, that the
constitutional implications of the tax benefit rule are not as
formidable as the court believed.  Nothing in the Sixteenth Amendment
itself would require such a rigid adherence to an annual accounting
concept as to preclude the making of adjustments in later periods
under the "balancing entry" theory articulated in South Dakota
Concrete whether or not any "income" as such has been received in the
year of the adjustment.  As this Court noted in United States v.
Skelly Oil Co., supra, 394 U.S. at 684, "the annual accounting concept
does not require us to close our eyes to what happened in prior
years." At all events, as the Eighth Circuit noted in Lamont v.
Commissioner, supra, the tax is imposed not on fictional income but on
the restoration to taxable income of the real gains that escaped
taxation in the first instance as a result of the prior deduction.

   /18/ Petitioner Hillsboro Bank complains (Br. 10-11) that the
"inconsistent event" formulation of the tax benefit rule articulated
in Estate of Block v. Commissioner, 39 B.T.A. 338, 341 (1939), aff'd,
111 F.2d 60 (7th Cir.), cert. denied, 311 U.S. 658 (1940) -- is
broader than was required by the facts of that case which involved an
actual recovery.  Under that formulation, "(w)hen recovery or some
other event which is inconsistent with what has been done in the past
occurs, (then) adjustment must be made in reporting income for the
year in which the change occurs." Tennessee-Carolina Transportation,
Inc. v. Commissioner, 582 F.2d 378, 382 (6th Cir. 1978), cert. denied,
440 U.S. 909 (1979);  First Trust & Savings Bank v. United States, 614
F.2d 1142, 1145 (7th Cir. 1980).  Accord:  Rosen v. Commissioner, 611
F.2d 942, 944 (1st Cir. 1980);  Unvert v. Commissioner, 656 F.2d 483,
485 (9th Cir. 1981), cert. denied, No. 81-1467 (May 3, 1982).  See
also Bonaire Development Co. v. Commissioner, 76 T.C. 789, 797-801
(1981), appeal pending, No. 81-7469 (9th Cir.).

   But the "inconsistent event" formulation is an authoritative
synthesis of the tax benefit rule, as applied in the early cases.  It
encompasses the cases involving actual recoveries (such as South
Dakota Concrete and Estate of Block), cases involving what might be
characterized, at best, as "constructive" recoveries (such as G.M.
Standifer Construction Corp. v. Commissioner, supra), as well as cases
such as Barnett v. Commissioner, supra, and its progeny, in which no
recovery, either actual or constructive, could be attributed to the
taxpayer.

   See also, e.g., Mayfair Minerals, Inc. v. Commissioner, 456 F.2d
622 (5th Cir. 1972);  Bear Manufacturing Co. v. United States, 430
F.2d 152 (7th Cir. 1970), cert. denied, 400 U.S. 1021 (1971);  Lime
Cola Co. v. Commissioner, 22 T.C. 593, 601-602 (1954);  Chicago, R.I.
& P. Ry. v. Commissioner, 13 B.T.A. 988, 1022-1023 (1928), aff'd, 47
F.2d 990, 992 (7th Cir.), cert. denied, 284 U.S. 618 (1931), where, as
in G.M. Standifer Construction Corp., the tax benefit rule was applied
to require taxpayers to include in income the amount of liabilities
that had been accrued and deducted but never paid.

   /19/ Pursuant to Section 362(a) of the Code, the corporation was
required to take the partnership's basis in the receivables (face
amount less the reserve).  Hence, the corporation would have had to
take into income any collections in excess of its basis in the
receivables, just as the partnership would have been required to do.

   /20/ As Rev. Rul. 78-278, Rev. Rul. 78-279 and Rev. Rul. 78-280,
1978-2 Cum. Bull. 134, 136 and 139, point out, the decision in Nash
would not necessarily preclude the application of the tax benefit rule
with respect to bad debt reserves where a subsidiary distributes its
assets to its parent pursuant to a liquidation under which the assets
acquire a new basis pursuant to Section 334(b)(2) of the Code.  For
example, where accounts receivable had a value greater than the face
value of such accounts less the bad debt reserve and where the
transferee acquired the account subject to a basis equal to that
greater amount, the transferor would be required, under those rulings,
to restore to income the excessive additions to its bad debt reserve.
In such circumstances, of course, the transferee, having acquired a
new basis for the receivables, would be permitted to collect the full
net value of the transferred accounts without realizing additional
income, and would be entitled to claim further loss deductions in the
event any lesser amounts were ultimately recovered.  See also Home
Savings & Loan Association v. United States, 514 F.2d 1199, 1200-1201
(9th Cir. 1975), cert. denied, 423 U.S. 1015 (1975), requiring the
restoration of a previously deducted bad debt reserve to income on
such a liquidation governed by Sections 332 and 334(b)(2).

   /21/ The refund checks in First Trust were made out jointly to the
bank and its shareholders, while in Hillsboro they were issued
directly to the shareholders.  That, however, is a distinction without
a difference since the Appellate Court of Illinois in Lincoln National
Bank v. Cullerton, 18 Ill. App. 3d 953, 958-959, 310 N.E.2d 845,
848-849 (1974), ruled that, pursuant to Ill. Ann. Stat. ch. 120,
Sections 676.01 (Smith-Hurd Cum. Supp. 1981), the amounts deposited in
the escrow account belonged to the individual shareholders, not to the
banks that made the deposits.  See also Bank & Trust Co. v. Cullerton,
25 Ill. App. 3d 721, 324 N.E.2d 29 (1975).  Accordingly, the bank in
First Trust was obligated, as noted by the court of appeals in
Hillsboro (H. Pet. App. A-6), to endorse over those refund checks to
its individual shareholders.

   /22/ Hillsboro contends (H. Br. 21) that it cannot be found to have
distributed dividends unless they have been declared as such by its
board of directors.  It is well settled, however, that for federal tax
purposes, dividend distributions may take man forms, and need not be
formally declared or even intended.  See, e.g., Baumer v. United
States, 580 F.2d 863, 876 (5th Cir. 1978);  Honigman v. Commissioner,
466 F.2d 69, 73 (6th Cir. 1972).  See also Commissioner v. Gordon, 391
U.S. 83, 89-91 (1968).  See generally B. Bittker & J. Eustice, Federal
Income Taxation of Corporations and Shareholders Paragraph 7.05, at
7-27, 7-28 (4th ed. 1979).

   /23/ While the provisions of Ill. Ann. Stat. ch. 120, Section
676.01 (Smith-Hurd Cum. Supp. 1981), providing that "(e)ach taxpayer
for whom such tax payments are placed in escrow shall be eligible for
automatic full repayment from the county collector if such personal
property taxes are ultimately held to be invalid" was not finally
approved until July 27, 1972, some 21 days after the amounts in
question were paid, the bill itself had passed in the Illinois General
Assembly on June 29, 1972.  See 1972 Ill. Laws, Pub. Act 77-2133.

   /24/ If the Bank had simply withheld from dividends an amount
sufficient to pay the taxes, the shareholders would presumably have
been entitled to claim the deduction themselves under Section
164(a)(2).  The Bank then would not have been entitled to claim a
deduction under Section 164(e).  See Wisconsin Gas & Electric Co. v.
United States, 322 U.S. 526 (1944).

   /25/ Commissioner v. First Security Bank, 405 U.S. 394 (1972), upon
which Hillsboro relies (H. Br. 8), is not in point.  There, this Court
ruled that the Commissioner could not allocate income under Section
482 of the Code to certain banking subsidiaries of a holding company
where such subsidiaries did not receive and were legally prohibited
from receiving the income in question.  The present case, however, in
no way involves an allocation of income, under Section 482 or
otherwise, among related parties.  Rather, the Commissioner's position
here is based on the fact that the Bank itself enjoyed the benefit of
a deduction that is no longer justified.

   /26/ There is no indication in the record that any part of the
$56,565 liquidation date value was due to an increase in the market
price of cattle feed between the date the feed was purchased and the
date of liquidation.  If that were the case, however, the amount
includable in Bliss' income under the tax benefit rule would, of
course, be limited to the actual cost of that feed.  See Tennessee
Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440, 448
(1975).  It is the purpose of the tax benefit rule to counter-balance
prior, unwarranted deductions, not to tax asset appreciation caused by
market forces.

   /27/ The net result in these cases would be precisely the same as
if the feed had been retained and used by the transferor itself in its
succeeding taxable years, viz., there would have been a one-year
deferral of tax to the extent the cost of unused feed was used to
offset otherwise taxable income for the first year.  While the use of
inventory accounting in the first instance would have eliminated even
this temporary distortion in income, the temporary shifting of income
is considered too inconsequential to mandate the use of inventories in
such cases.

   The transfer of property to a corporation in a transaction governed
by Section 351 is similarly treated as a mere change of form, with the
corporation taking the property subject to the same basis as it had in
the hands of the transferor.  See B. Bittker & J. Eustice, supra,
Paragraphs 3-01 and 3.12.  Cf. Nash v. United States, supra, 398 U.S.
1.

   /28/ Section 333 permits the shareholders to limit the amount of
gain recognized on the liquidation to their pro rata shares of the
corporation's earnings and profits or, if greater, the amount of money
and certain securities acquired in the liquidation.

   /29/ Respondent Bliss Dairy (Br. in Opp. 2, 9) apparently takes the
position that its shareholders did not take a "stepped-up" basis in
the corporate assets, but took a carryover basis in those assets
because their basis in the assets was equal to their basis in the
stock of the corporation.  But that is not a carryover basis within
the parlance of the tax law.  The term carryover basis connotes the
same basis in the same item of property.  Hence, if the shareholders
took the corporation's zero basis in the feed, they could have a
carryover basis because the corporation's basis would "carry over" to
the shareholders.  But where, as here, the shareholders' basis in the
feed (and other assets) was computed by reference to their basis in
their stock, their basis in the feed will necessarily be greater than
zero.  In these circumstances, they are said to have taken a
"stepped-up" basis in the feed.

   /30/ Although the exact amount of the shareholders' "stepped-up"
basis in the feed is not in the record, it is clear that the
shareholders took a "stepped-up" basis to at least some degree.  See
page 5, note 4, supra.

   /31/ Had the corporation instead chosen to sell the expensed feed
and to distribute the proceeds to the shareholders, it is settled that
it would have been required to restore the previously deducted amount
to income even though the liquidation might have qualified under the
provisions of Section 337 of the Code (providing for nonrecognition of
gain on the sale of property pursuant to a liquidation plan meeting
the requirements of that section).  See, e.g., Anders v. United
States, 462 F.2d 1147 (Ct. Cl.), cert. denied, 409 U.S. 1064 (1972);
Connery v. United States, 460 F.2d 1130 (3d Cir. 1972);  Spitalny v.
United States, 430 F.2d 195 (9th Cir. 1970);  Commissioner v. Anders,
414 F.2d 1283 (10th Cir.), cert. denied, 396 U.S. 958 (1969).  While
the corporation itself, in such a case, converts the "expensed"
property into money, the distribution of such property to
shareholders, with a "stepped-up" basis -- enabling them either to
claim a second deduction or to sell the property themselves, and
thereby acquire the same amount of cash (largely or entirely tax-free)
that they would have received had the corporation sold the property --
is, we submit, equally inconsistent with the assumptions under which
the deduction was originally claimed and with the corporation's
retention of the "tax benefit" resulting from its practice of
deducting the cost of such property in advance of its consumption.
Since the economic positions of the parties are precisely the same in
both instances, the tax benefit rule is likewise applicable here.

   While this case and Tennessee-Carolina, supra, involve liquidation
distributions, the same problem would be presented in an "inkind"
distribution of "expensed" property in a non-liquidating context.  In
such a case, the shareholders would be charged with dividend income to
the extent that the corporation had earnings and profits (Sections
301(a) and (c), and 316 of the Code).  But absent the tax benefit
rule, the corporation could retain the benefit of a tax deduction
(and, hence, a reduction in earnings and profits) that becomes
unjustified in light of the distribution.  Thus, unless the tax
benefit rule required the corporation to restore the previously
deducted amount to income, a corporation could distribute "expensed"
property remaining on hand at the end of each taxable year, and
thereby enjoy the benefit of making annual tax-deductible dividends.
Indeed, one could easily imagine a case in which the deduction for
unconsumed materials distributed to shareholders would be sufficient
to reduce earnings and profits to zero, thereby rendering such
"dividends" non-taxable to the shareholders as well.

   /32/ It is in fact arguable that the discussion of the tax benefit
rule in South Lake Farms is dicta.  See 81-930 Pet. 8-9 n.6.

   The Ninth Circuit itself has subsequently recognized that Section
336 of the Code is not a bar to the inclusion of an overstated prior
deduction in income in the year of liquidation.  In Home Savings &
Loan Association v. United States, 514 F.2d 1199 (9th Cir. 1975), the
stock in a savings and loan association was first purchased by another
savings and loan association, which thereafter liquidated the acquired
association.  The court held that the liquidated association was
required to include in its income certain amounts it had deducted as
additions to its bad debt reserve prior to the take-over and
liquidation.  At the time the liquidating corporation's assets were
distributed to the acquiring parent corporation, it became clear that
the projection of bad debt expenses inherent in the reserve account
was overstated.  The court viewed the liquidation and distribution as
an event inconsistent with the former corporation's prior deductions
for the reserves.  Although the court stated in its opinion that it
did not intend to impair the authority of South Lake Farms (514 F.2d
at 1201 n.1), the holdings of Home Savings & Loan, on the one hand,
and South Lake Farms and the present case, on the other, cannot fairly
be reconciled.  See First Trust & Savings Bank v. United States,
supra, 614 F.2d 1146 n.5.

   /33/ Compare, e.g., Nash v. United States, supra, 398 U.S. 1, where
stock received on the transfer of the unincorporated business to a
corporation reflected the actual "net" value of accounts receivable,
and thus did not constitute a "recovery" of the amount properly added
to bad debt reserves.

   /34/ Despite the broad "no gain or loss" language of Section 337,
the courts have required the recognition of income on the sale of
corporate assets in a variety of contexts, including, as noted above,
the sale of previously "expensed" items (e.g., Anders and Spitalny,
supra), the transfer of accounts receivable that had previously been
written off in part through additions to a bad debt reserve (West
Seattle National Bank v. Commissioner, 288 F.2d 47 (9th Cir. 1961)),
and the transfer of contracts under which the right to receive partial
or complete payment has already been earned (e.g., Commissioner v.
Kuckenberg, 309 F.2d 202 (9th Cir. 1962), cert. denied, 373 U.S. 909
(1963));  Family Record Plan, Inc. v. Commissioner, 309 F.2d 208 (9th
Cir. 1962), cert. denied, 373 U.S. 910 (1963);  and Midland-Ross Corp.
v. United States, 485 F.2d 110 (6th Cir. 1973)).  See B. Bittker & J.
Eustice, supra, Paragraph 11.65, at 11-82 through 11-85.  It is well
established that Section 336 would not preclude attributing income to
the corporation itself on assignment of income principles where the
right to receive contract payments is distributed to shareholders.
See, e.g., Wood Harmon Corp. v. United States, 311 F.2d 918, 921-923
(2d Cir. 1963);  Williamson v. United States, 292 F.2d 524, 528-530
(Ct. Cl. 1961).  Given the purpose of Section 337 to eliminate the
disparity in treatment between liquidation sales and liquidation
distributions, the Sixth Circuit properly concluded that Section 337
should be construed, insofar as possible, so as to achieve the same
result.  Midland-Ross Corp. v. United States, supra, 485 F.2d at
114-115, 118.  See also Estate of Munter v. Commissioner, 63 T.C. 663,
671-677 (1975).

   /35/ Indeed, in a Secton 333 liquidation, such as here, the result
is even more egregious because the shareholders' "gain" on the
liquidation distribution is itself limited to their pro rata share of
corporate earnings and profits which, of course, are themselves
reduced by the deductions for items that were not actually consumed in
the corporation's own operations.

   Appendix Omitted