UNITED STATES COURT OF APPEALS

For the Fifth Circuit

No. 95-60036

HUGHES & LUCE, L.L.P.,

ALAN J. BOGDANOW, TAX MATTERS PARTNER,

Petitioner-Appellant,

versus

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

Appeal from the United States Tax Court

November 15, 1995

Before REAVLEY, JOLLY, and WIENER, Circuit Judges.

WIENER, Circuit Judge.

This federal income tax case finds a law firm appealing from

an adverse judgment rendered by the United States Tax Court. The

underlying dispute arose when, during the course of an audit, the

Internal Reven ue Service (IRS) determined that "Service Costs"

deducted by Hughes & Luce, L.L.P. should be treated as

nondeductible loans to clients. The instant controversy concerns

the collateral issue of the proper tax treatment of currentlyreceived reimbursements of "Service Costs" previously deducted by

the law firm as expenses in earlier tax years. The Tax Court

upheld the IRS's adjustment to Hughes & Luce's then-current taxable2

income, holding that the duty of consistency requires Hughes & Luce

to recognize income for these reimbursements. The Tax Court

declined to apply the tax benefit rule

, however, relying on the socalled "erroneous deduction exception." Agreeing with every other

circuit court that has addressed the erroneous deduction exception,

we conclude that it should be rejected, and t hat the judgment of

the Tax Court should be affirmed but on the basis of the tax

benefit rule.

I

FACTS AND PROCEEDINGS

Hughes & Luce, L.L.P. is a Texas general partnership engaged

in the practice of law. It commenced doing business on November 1,

1976. Hughes & Luce uses the cash receipts and disbursements

method of accounting for income tax purposes and files its tax

returns on a calendar year basis.

Although the terms of an engagement differ from client to

client, Hughes & Luce customarily bills clients separately for outof-pocket costs paid to third parties for expenses incurred in

connection with the firm's representation of those clients. These

costs include expenses for court costs, filing fees, expert witness

fees, travel and meals, long-distance telephone charges, delivery

services, and the like ("Service Costs").

On its income tax returns for the years 1976 through 1989,

Hughes & Luce deducted Service Costs as ordinary and necessary

business expenses in the year in which the expense was paid.

Reimbursements of these costs were included in its ordinary income1 The majority of these Service Costs were described on

Hughes & Luce's income tax return as "Other Rebillable Expenses,"

and the remainder was interspersed among eighteen other categories

of expenses.

2 The parties have stipulated to the amounts above. As

acknowledged by the Tax Court, the $450 discrepancy between the

total reimbursements and the components thereof is immaterial for

purposes of our decision.

3 in the year received. Often the reimbursements were received in a

taxable year subsequent to the year in which the Service Costs had

been deducted as business expenses.

On March 30, 1992, the IRS began an audit of Hughes & Luce's

timely filed 1989 tax return. During the course of this audit, the

IRS challenged Hughes & Luce's treatment of the Service Costs. The

IRS contended that the firm's payments for Service Costs should be

treated as loans to clients. Accordingly, the Service Costs should

be neither deductible when pai d nor includible in income when

reimbursed. For purposes of this case, Hughes & Luce concedes that

the Service Costs are properly treated as loans to clients for

taxable year 1989 and following.

For the taxable year 1989, Hughes & Luce had deducted Service

Costs in the amount of $2,367,535. 1 Reimbursements totaling

$2,398,825 were included in income for this same year. Of the

total reimbursements, $1,908,509 was attributable to Service Costs

paid and deducted in 1989. The remainder of $490,766 was

attributable to Service Costs paid and deducted in years prior to

1989. 2 It is these latter reimbursements that are at issue in this

case. As the statute of limitations had expired for the years

prior to 1989, the IRS was precluded from making an adjustment to3 The adjustment was calculated as follows:

Service Costs deducted but not

reimbursed as of December 31, 1988 $490,766

Service Costs deducted

in 1989 $2,367,535

Service Costs reimbursed

in 1989 (2,398,825) ( 31,290)

Less: Bad debt deduction ( 37,019)

Adjustment to Hughes & Luce's

taxable income for 1989 $422,457

4 those years to disallow the deduction of these Service Costs.

Hughes & Luce essen tially contends that none of the

reimbursements received in 1989 are taxable income because the IRS

determined them to be loan repayments, and loan repayments are not

ordinarily includible in income. The IRS counters that the

reimbursements received in 1989 but attributable to costs advanced

and deducted as expenses in years prior to 1989 are includible in

taxable income for 1989 under either (1) the tax bene fit rule or

(2) the duty of consistency, which is also known as the doctrine of

quasi-estoppel. On June 1, 1993, the IRS sent Hughes & Luce a

Notice of Final Partnership Administrative Adjustment for its 1989

tax year, reflecting an adjustment to its taxable income of

$422,457. 3

Hughes & Luce filed a petition in the Tax Court challenging

the IRS's determination. The Tax Court held that, as the

deductions for Service Costs in years prior to 1989 were improper,

the tax benefit rule was inapplicable under the so-called

"erroneous deduction exception." The court went on to hold,4 E state of Hudgins v. Commissioner

, 57 F.3d 1393, 1396 (5th

Cir. 1995).

5 H illsboro Nat'l Bank v. Commissioner

, 46 0 U.S. 370, 377

(1983) (citing Burnet v. Sanford & Brooks Co.

, 282 U. S. 359, 365

(1931)).

6 Id.

7 Id. at 377, 381.

5 however, that Hughes & Luce was required to include the amount in

issue in its income under the duty of consistency. Hughes & Luce

now appeals that decision.

II

ANALYSIS

A. S TANDARD OF R EVIEW

In reviewing decisions of the Tax Court we apply the same

standards used in reviewing a decision of the distri ct court:

Questions of law are reviewed de novo; findings of fact are

reviewed for clear error. 4

B. T AX B ENEFIT R ULE

The federal income tax is ba sed on an annual accounting

system, which is "a practical necessity if [it] is to produce

revenue ascertainable and payable at regular int ervals." 5 Strict

adherence to an annual accounting period, however, may create

transactional inequities. 6 The tax benefit rule was adopted in an

equitable effort to mitigate some of the inflexibilities of the

annual accounting system by approximating the results that would be

produced in a system based on transactional rather than annual

accounting. 78 I d. at 383-84; Frederick v. Commissioner

, 101 T.C. 35, 41

(1993).

9 Hillsboro , 460 U.S. at 383-84.

1 0 S ee Canelo v. Commissioner

, 53 T.C. 217, 226 (1969), aff'd

on other grounds , 447 F.2d 484 (9th Cir. 1971).

6 The tax benefit rule includes an amount in income in the

current year to the extent that: (1) the amount was deducted in a

year prior to the current year, (2) the deduction resulted in a tax

benefit, (3) an event occurs in the current year that is

fundamentally inconsistent with the premises on which the deduction

was originally based, and (4) a nonrecognition provision of the

Internal Reve nue Code does not prevent the inclusion of gross

income. 8 An event is fundamentally inconsistent with the premises

on which the deduction was originally based if that event would

have foreclosed the deduction had it occurred in the year of the

deduction. 9

The Tax Court held that application of the tax benefit rule

was improper in this case because of the "erroneous deduction

exception." That exception provides that the tax benefit rule

applies only when the original deduction was proper. 10 Because the

disbursement of a loan (i.e., Service Cost) is not a proper

deduction, the Tax Court concluded that the tax benefit rule did

not require Hughes & Luce to include the amount in issue in its

1989 taxable income.

In its opinion, the Tax Court noted candid ly that the

erroneous deduction exception has been criticized or rejected by1 1 S ee Unvert v. Commissioner

, 656 F.2d 483, 485-86 (9th Cir.

1981), cert. denied

, 456 U.S. 961 (1982); Union Trust Co. v.

Commissioner

, 111 F.2d 60, 61 (7th Cir.), cert. denied

, 311 U.S.

658 (1940); Kahn v. Commissioner

, 108 F.2d 748, 749 (2d Cir. 1940);

Commissioner v. Liberty Bank & Trust Co

. , 59 F.2d 320, 325 (6th

Cir. 1932).

1 2 Canelo v. Commissioner , 53 T.C. 217, 226-27 (1969), aff'd

on other grounds , 447 F.2d 484 (9th Cir. 1971).

7 many Courts of Appeals. 11 The Tax Court nevertheless applied this

exception in the instant case because we had not squarely addressed

this issue. We do so now and join the other circuits in rejecting

the erroneous deduction exception.

The rationale underlying the erroneous deduction exception

was explained by the Tax Court in Canelo as follows:

We realize that [the taxpayers] herein have r eceived a

windfall through the improper ded uctions. But the

statute of limitations requires eventual repos e. The

"tax benefit" rule disturbs that repose only if [the IRS]

had no cause to question the initial deduction, that is,

if the deduction was proper at the time it was taken.

Here the deduction was improper, and [the IRS] should

have challenged it before the y ears prior to 1960 were

closed by the statute of limitations. 12

Like the other Courts of Appeals before us, we are not persuaded by

this reasoning or by the arg uments advanced by Hughes & Luce in

support of this exception.

As other courts have observed, the i nclusion of the

reimbursements in income does not reopen the tax liability for the

prior year s SQ

albeit the result is much the same SQ and does not1 3 D obson v. Commissioner

, 320 U.S. 489, 493 (1943); Unvert

v. Commissioner

, 656 F.2d 483, 48 5-86 (9th Cir. 1981), c ert.

denied , 456 U.S. 961 (1982)

.

14 Unvert , 656 F.2d at 486.

8 implicate the statute of limitations. 1 3 The only taxable year

affected by application of the tax benefit rule is the year in

which the reimbursements are received, which year must be open for

the rule to apply at all. That these reimbursements are properly

treated as loan repayments does not prevent their taxation when, as

here, the loan disbursements were erroneously deducted in a prior

year as an expense. The tax benefit rule requires taxation because

of a previous ly created tax benefit, regardless of an item's

inheren t characteristics (i.e., whether repayment of a loan or

recovery of a deducti ble expense) and regardless of whether the

original deduction was proper or improper. 14 We also agree with the

court in Unvert that the erroneous deduction exception is poor

public policy in that it rewards the taking of improper tax

deductions. We therefore reject the erroneous deduction exception

and conclude that the tax benefit rule applies regardless of the

propriety of the original deduction.

Hughes & Luce argues that the Supreme Court's decision in

Hillsboro National Bank v. Commissioner effectively overruled prior

cases that rejected or criticized the e rroneous deduction

exception. Selectively pointing to language and examples in that

case, Hughes & Luce asserts that Hillsboro leaves no doubt that the

tax benefit rule can be applied only when the original deduction

was proper. We disagree, finding this to be a strained15 Hillsboro , 460 U.S. at 381.

16 See Hillsboro , 460 U.S. at 383-84.

9 interpretation of Hillsboro

.

At issue in Hillsboro was whether the tax benefit rule was

limited to situations in which a taxpayer recovers an amount

previously deducted or, alternatively, whether it also applies when

an event in a later year is fundamentally inconsistent with the

premise on which the deduction was claimed. 15 Neither the propriety

of the original deductions nor th e validity of the erroneous

deduction exception was ever in question in Hillsboro

. Thus, we

are unpersuaded by this argument.

Hughes & Luce also conten ds that there is no fundamentally

inconsist ent event in this case because the very nature of

"rebillable expenses" is that re imbursement of such expenses is

expected. Thus, Hughes & Luce insists, it is improper to invoke

the tax benefit rule. This argument misses the mark. In holding

that a fundamentally inconsistent event is a requirement to invoke

the tax benefit rule, the Supreme Court in Hillsboro expanded that

rule by refusing to limit it to situations involving an actual

recovery. The actual recoveries by Hughes & Luce of the Service

Costs at issue plainly are fundamentall y inconsistent events in

that they would have foreclosed the deduction had they occurred in

the same year as the disbursements. 16

C. D UTY OF C ONSISTENCY

As we affirm the Tax Court on the basis that the tax benefit

rule requires Hughes & Luce to include the amount at issue in its10

1989 taxable income, we need not and therefore do not consider the

Tax Court's holding that this same result is required under the

duty of consistency. This should not be construed as either

agreeing with or rejecting the Ta x Court's treatment of that

matter.

III

CONCLUSION

For the foregoing reasons, we reject the erroneous deduction

exception and conclude that the tax benefit rule applies regardless

of the propriety of the original deduction. We therefore affirm

the Tax Court's judgment, albeit we do so on the basis of the tax

benefit rule rather than on the reason expressed by the Tax Court.

AFFIRMED.