Opinion ID: 3014809
Heading Depth: 1
Heading Rank: 4

Heading: Burden of Proof of Deduction Amounts

Text: It appears, thus far, that Capital has at least a theoretical right to take § 165 loss deductions when its group insurance clients depreciation rather than deduction of individual cancelled contracts. The Commissioner’s argument has some intuitive appeal because there is a certain economic equivalence between the two procedures: assuming that the contracts will be cancelled in a predictable pattern, an amortization schedule based on that pattern would lead to roughly the same deductions as would deducting each cancelled contract individually. We note in passing that the Commissioner uses the word “depreciation,” although it would appear that the correct word is “amortization.” See Newark Morning Ledger, 507 U.S. at 571 n.1 (Souter, J., dissenting) (“Black’s Law Dictionary tells us that intangible assets are amortized, while tangible assets are depreciated.”). We treat the terms as interchangeable. We cannot find any legal basis on which to accept the Commissioner’s theory. To the extent that his depreciation argument rests on a theory that Capital’s contracts are a single indivisible asset, we have rejected that theory in the text. To the extent that it is a factual argument, it clearly fails: Capital has not attempted to take a depreciation deduction in order to approximate the average annual loss of contracts; instead, it has gone through the extraordinarily laborious exercise of counting cancelled contracts and valuing each one. To the extent that the Commissioner claims that a taxpayer may never take loss deductions when those deductions are economically similar to disallowed depreciation deductions, the argument is novel and unsupported. Instead, the regulations specifically provide that taxpayers may take a § 165 deduction for the loss of nondepreciable property. See Treas. Reg. § 1.165-2(a). A § 165 loss is sustained where the loss is “evidenced by closed and completed transactions, fixed by identifiable events, and . . . actually sustained during the taxable year.” Treas. Reg. § 1.165-1(b). This requirement distinguishes § 165 losses from § 167 amortization: a § 165 loss requires “some step that irrevocably cuts ties to the asset,” Corra Res., Ltd. v. Comm’r, 945 F.2d 224, 226-27 (7th Cir. 1991), and a § 165 “loss is not sustained and is not deductible because of mere decline, diminution or shrinkage of the value of property,” A.J. Indus., Inc. v. United States, 503 F.2d 660, 664 (9th Cir. 1974). Here, an identifiable event—a customer’s cancellation decision—has severed Capital’s control over each of its lost contracts. These losses are in form and function § 165 abandonment losses, and may not be characterized as mere amortization deductions. 16 cancel contracts that were in force on January 1, 1987. Furthermore, Capital’s basis in each of these contracts—and thus the amount of each deduction—is equal to the fair market value of each contract as of January 1, 1987. That said, the calculation of this fair market value is difficult and hotly disputed, as is the question who bears the burden of proof.
The burden of proof in a Tax Court case is on the petitioner, but the Commissioner bears the burden of proof “in respect of any new matter.” Tax Ct. R. 142(a)(1). The Tax Court placed the burden of proving the contracts’ value on Capital. See 122 T.C. at 246 n.11. Capital, however, contends that the Tax Court should have shifted the burden of proof to the Commissioner, because “the Notice of Deficiency did not raise the issue of Capital’s valuation,” or in the alternative because the notice “was arbitrary for finding no value.” The first of these contentions is based on the fact that the notice denied that Capital had established “any” loss. Capital claims that the dispute over its specific valuation is therefore “new matter” within the meaning of Rule 142. The Tax Court found that the notice’s “broad language relating to whether Petitioner sustained ‘any loss’ . . . includes the factual valuation issue.” 122 T.C. at 246 n.11. We agree with the Tax Court: the notice of deficiency challenging Capital’s entire deduction necessarily raised the valuation issue at the heart of that deduction. Capital’s more compelling contention is that the Commissioner’s initial notice of deficiency denying any deduction was per se unreasonable. In deficiency cases brought in Tax Court, the petitioner may shift the burden of proof to the Commissioner if it can prove that the Commissioner’s assessment is “arbitrary and excessive.” Helvering v. Taylor, 293 U.S. 507, 515 (1935). Even the Commissioner’s experts agree that these contracts had some value. Therefore, Capital argues, it has demonstrated that the Commissioner’s zero-deduction position is unreasonable, and so the burden shifts to the Commissioner to prove the correct amount of the deductions. Taylor, however, concerned the apportionment of income, 17 not the calculation of deductions. Indeed, the Taylor Court stated in dictum that “the burden is upon the taxpayer to establish the amount of a deduction claimed,” even where the Commissioner’s position is unreasonable. Id. at 514. We have applied Taylor to deduction claims in circumstances closely analogous to this case. In R.M. Smith, Inc. v. Comm’r, 591 F.2d 248 (3d Cir. 1979), the Commissioner disputed the amount that the taxpayer could deduct for amortization of certain patents. The taxpayer’s basis for deductions depended upon the fair market value of the patents at the time they were acquired. The taxpayer and the Commissioner put forward widely varying calculations of this fair market value; the Tax Court, rather than choosing one or the other, split the difference and entered a judgment based on its own valuation. The taxpayer appealed, arguing that (1) once it had proven that the Commissioner’s valuation was “unduly pessimistic,” the burden shifted to the Commisssioner, and (2) because the Tax Court rejected the Commissioner’s valuation, it was required to accept Smith’s valuation . We agreed with the first of these contentions: Smith states that it had the burden of proving that the Commissioner’s determination of the gross values, which initially amounted to $10,000, was arbitrary. Having established that the calculation was in error, Smith was not required to prove the correct figure. The Commissioner had the burden of establishing the proper valuation and thus the actual tax owed. This much is an accurate statement of the law. Id. at 251 (citing Taylor, 293 U.S. 507; Fed. Nat’l Bank v. Comm’r, 180 F.2d 494, 497 (10th Cir. 1950)). But we rejected Smith’s second contention that the Tax Court was bound to award the deduction requested by Smith merely because the Commissioner’s valuation was unreasonable. We continued: Where Smith’s argument fails is in suggesting that the refusal of the tax court to accept the Commissioner’s evidence requires this court to reverse the trial judge with instructions to expunge 18 the deficiencies. The teaching of Helvering v. Taylor . . . and Federal National Bank v. Commissioner of Internal Revenue . . . is that the appropriate remedy in the absence of evidence of proper valuation is a remand to allow for additional evidence to be presented. In this case, however, sufficient evidence was introduced to allow the tax court to reach a reasonable conclusion. The court is not limited to simply choosing one of the two values proffered. It is appropriate for it to evaluate all of the evidence and to make an independent determination that does not necessarily accept the valuation of either party. Id. Indeed, in Taylor itself, the Supreme Court did not reject the Commissioner’s arbitrary claimed deficiency; instead, it affirmed the decision of the Court of Appeals remanding the case so that the Board of Tax Appeals might “hear[] evidence to show whether a fair apportionment might be made and, if so, the correct amount of the tax.” 293 U.S. at 516. In sum, the taxpayer bears the burden of proof on valuation, but where the Commissioner’s alternative proposed valuation is unreasonable, the Tax Court must make a fair apportionment, and is not confined to choosing between the two proffered valuations. B. Proof of Separate Valuation; the Burden Framework Nonetheless, as Taylor recognized, it is not always possible for the Tax Court to make a “fair apportionment” of a taxpayer’s obligations and basis. 293 U.S. at 516. Capital argues that its burden is only to prove that its aggregate deductions are correct, even if it cannot apportion them precisely. See S. Pac. Trans. Co. v. Comm’r, 75 T.C. 497 (1980); DiLeonardo v. Comm’r, 79 T.C.M. (CCH) 1820 (T.C. 2000). The Commissioner disagrees, arguing that Capital must prove the value of each contract, and may not take an approximate deduction not based in the value of the contracts actually lost. Newark Morning Ledger, which presents significant factual analogies to this case, set a high bar for the taxpayer seeking to prove deductions. The Court held that the taxpayer bears the burden of proving “that a particular asset can be valued and that it has a limited useful life,” and noted that “that burden will often prove too 19 great to bear.” 507 U.S. at 566. Most mass asset cases before and after Newark Morning Ledger make similar statements. These cases put the burden on the taxpayer of “establish[ing] reasonably accurately a basis in the particular account on which the loss is claimed.” Sunset Fuel, 519 F.2d at 783; see also 7 Mertens, Law of Federal Income Taxation § 28.15, at 49-50 (rev’d ed. 2001). Some of these cases go even further, echoing Newark Morning Ledger’s warning that the burden will often be too great for the taxpayer to bear. See, e.g., Globe Life & Accident Ins. Co. v. United States, 54 Fed. Cl. 132, 136 (2002). There is some tension between the rule of Newark Morning Ledger, which places on the taxpayer a “heavy burden” of proving that its intangible assets may be valued separately, and the rule of Taylor and R.M. Smith, which allows the Tax Court to determine a fair value when neither the Commissioner’s nor the taxpayer’s valuation is completely convincing. We think, however, that these cases can be reconciled in a straightforward manner. Newark Morning Ledger stands for the proposition that the taxpayer always bears the burden of proving that his lost intangible assets are susceptible of separate valuation. A taxpayer who cannot carry that burden possesses a mass asset, and may not depreciate it or deduct losses of components of that asset. The Commissioner may always put the taxpayer to his proofs in such a case, and the Commissioner’s litigation position rejecting the entire claimed deduction will not necessarily be unreasonable. But this heavy burden applies only to the taxpayer’s obligation to prove that his intangible assets may be valued separately and with reasonable precision. What we derive from the foregoing is that, if the taxpayer can satisfy that burden, the process of proof changes. Once a court is satisfied that the intangible assets may be valued separately, its obligation is to find the correct value. The taxpayer and the Commissioner may submit their own proposed valuation, and dispute over the merits of each side’s claims. Where the Commissioner refuses to submit any valuation, or where his valuation is arbitrary, the court will essentially be forced to start from the taxpayer’s valuation. The court may accept this valuation if it is reasonable, or it may modify it to take into account objections raised by the Commissioner or by the court sua sponte. But it will not, in our view, be reasonable for a court to reject the taxpayer’s valuation out 20 of hand simply because the Commissioner has identified minor flaws in the valuation. Once it is established that the assets have a reasonably ascertainable value, the court is obligated to seek the correct value of the contracts not, upon catching the taxpayer in an error, to deny any deduction automatically. See R.M. Smith, 591 F.2d at 251. Similarly, the dispute over whether Capital must prove only its aggregate 1994 deduction, or the individual value of each contract lost in that year, is a chimera. Under Newark Morning Ledger, Capital must of course prove that each of the 376 lost contracts has an individual value that exists separately from that of the other contracts. But the court need not find each individual valuation convincing in all respects in order to accept an aggregate deduction. A court might find that ten individual contracts each have a separate value, while being unable to put a precise dollar value on each one. In such a case, if the court can easily calculate the aggregate value of the ten contracts, while remaining uncertain about the individual values, the taxpayer has satisfied its burden under Newark Morning Ledger and may prove his aggregate deduction under the logic of South Pacific Transportation and DiLeonardo.