Court Opinion

ID: 9465902
Source: CourtListenerOpinion
Date Created: 2023-08-05 00:59:25.395611+00
Date Added: 2024-06-11T17:39:26.281912
License: Public Domain

ALVIN B. RUBIN, Circuit Judge,
dissenting in part:
I concur with my brethren in affirming the decision of the Tax Court disallowing any corporate deduction for accrued salaries forgiven by the individual taxpayers. I must respectfully disagree with their decision in Part II that the cancellation of corporate indebtedness for interest payable to Mr. Hunt constituted a contribution to capital and was thus not taxable to the corporation.
The tax benefit rule is a simple precept based on economic reality: when a taxpayer takes a deduction for an expense in one year, and then in a later year the amount is either not paid or, having been paid, is recouped, the amount of the deduction must be restored to the taxable income of the taxpayer in the later year. We deal here with the inherent tension between that patently sound rule and the explicit exemption of capital contributions from the taxable *752income of corporate taxpayers contained in the Internal Revenue Code, 26 U.S.C. § 118(a). The appellee corporations have deducted the accrued interest payable to Mr. Hunt, thereby gaining a tax benefit, but they have never paid it. If the cancellation of the debt they owe for this interest does not result in taxable income to the corporations, they have in effect taken a deduction for an expense that will never be paid,1 but Mr. Hunt will never report any of this sum as interest income.2 An income tax deduction will have been realized for a fictitious expense.
Once upon a time, more than 40 years ago, the Commissioner appeared to countenance this anomalous result. In defining a contribution to corporate capital, the Regulations in effect from 1918 to 1939 3 provided, in part:
If a shareholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation.
Interpreting this regulation, the Second Circuit early and consistently concluded that any gratuitous cancellation of a debt, even one consisting of accrued interest, constituted a contribution to capital and was nontaxable, despite the Commissioner’s appeals to the tax benefit rule. See Carroll-McCreary Co. v. Commissioner, 2 Cir. 1941, 124 F.2d 303; Commissioner v. Auto Strop Safety Razor Co., 2 Cir. 1934, 74 F.2d 226. The Eighth Circuit interpreted the regulation somewhat more narrowly, concluding that only principal, not accrued interest, was shielded from tax impact on the corporation. Helvering v. Jane Holding Corp., 8 Cir. 1940, 109 F.2d 933, cert. denied, 310 U.S. 653, 60 S.Ct. 1102, 84 L.Ed. 1418 (dictum).
In 1938 the Commissioner altered the regulation to make clear that the interest portion of a cancelled corporate debt was taxable to the extent of any prior tax benefit to the corporation. See Rev.Rul. 73-432, 1973-2 Cum.Bull. 17. As amended, the regulation (now Regulation § 1.61-12(a)) provides, in part;
In general, if a shareholder in a corporation which is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation to the extent of the principal of the debt.
That this modification in the regulation had little initial effect on the course of judicial decisions is likely attributable to the Supreme Court’s decision in Helvering v. American Dental Co., 1943, 318 U.S. 322, 63 S.Ct. 577, 87 L.Ed. 785. While the case is analogous, unlike the majority, I must conclude that it is distinguishable from this one both on its facts and on the issues faced. In American Dental the Court considered the taxability of accounts cancelled by non-shareholder creditors of a corporation that arose out of expenses for rents and interest. The Commissioner agreed that the only issue before the Court was whether the forgiveness was a gift; if so, he conceded that it was excludable from corporate income. The Court decided as matter of law that the cancellation was a gift. The fact that a prior tax benefit had been obtained — not pressed by the Commissioner in that case— did not motivate the Court to exclude the transaction from the category of a “gift” within the meaning of the Code.
American Dental could not possibly have involved a contribution to corporate capital *753because the forgiveness did not emanate from stockholders; nevertheless, the opinion did mention the following as an example of transactions exempt from taxation:
Where a stockholder gratuitously forgives the corporation’s debt to himself, the transaction has long been recognized by the Treasury as a contribution to the capital of the corporation, [citing Commissioner v. Auto Strop Safety Razor Co., supra.]
318 U.S. at 328, 63 S.Ct. at 580. American Dental was decided in 1943, and involved a 1937 transaction; it was easy for the court to overlook, in discussing an issue not argued, the 1938 change in the regulation.
Nonetheless, following American Dental, courts continued to find gratuitous cancellations of corporate indebtedness, including both principal and interest, to be nontaxable gifts. See, e.g., McConway & Torley Corp. v. Commissioner, 1943, 2 T.C. 593; Pancoast Hotel Co. v. Commissioner, 1943, 2 T.C. 362; George Hall Corp. v. Commissioner, 1943, 2 T.C. 146. Cf. Reynolds v. Boos, 8 Cir. 1951, 188 F.2d 322 (forgiveness of rental indebtedness by lessor). The fact that such gifts might be considered contributions to capital, and therefore subject to the amended regulation, had no impact on the decisions. In these cases and others, confronted with what superficially appeared to be precedent establishing the nontaxability of gratuitous forgiveness of corporate indebtedness, the courts applied American Dental to exempt cancellation of both principal and interest debts as contributions to capital, thus going further than the gift-to-the-corporation situation.
Two of these cases can be explained on other grounds. In Utilities & Industries Corp. v. Commissioner, 1964, 41 T.C. 888, rev’d on other grounds sub nom. The South Bay Corp. v. Commissioner, 2 Cir. 1965, 345 F.2d 698, the nontaxability of the discharge of indebtedness was also required by bankruptcy regulations. No tax benefit was gained by the company in Commissioner v. Fender Sales, Inc., 9 Cir. 1964, 338 F.2d 924, because the accrued, unpaid officers’ salaries were discharged in exchange for common stock of equal market value on which the officers were taxed, and the court did not find itself compelled to decide whether there had been a contribution to capital.
The only such case that actually presented the issue we face here is Hartland Associates v. Commissioner, 1970, 54 T.C. 1580. The Tax Court there stated:
The nontaxability of the gratuitous cancellation of an indebtedness applies equally to the principal and interest portions of the indebtedness. . . . It is of little consequence in determining the result of the cancellation of interest indebtedness that the interest had been deducted by the debtor in prior years. The imposition of tax liability on the basis of prior tax benefits has been uniformly rejected by the courts in the case of gratuitous forgiveness of a debt. . . . Sections 102 and 118, which govern taxability of such cancellations, will not be overridden by the abstract notion of tax benefit. [54 T.C. at 1585-86.]
I think that the Tax Court and my brethren here have failed to apprehend the distinction between gift cases, such as American Dental, and capital contribution cases. I would agree that gifts to corporations are nontaxable under the Internal Revenue Code, 26 U.S.C. § 102, to the full extent of principal and interest. The regulations defining a “gift” do not compel a different conclusion. However, Putoma does not contend — nór did the Tax Court decide — that the transaction here was a gift. This case involves an alleged contribution to capital, pure and simple. If the corporation has previously obtained a tax benefit by virtue of its accrual system of accounting, and later secures a release of its obligation to incur the expenses accrued, such a cancellation of indebtedness constitutes a contribution to capital in the tax sense only to the extent of the principal of the debt, as the regulations clearly provide; any debt for interest eliminated in the transaction must *754be recognized as income unless it is exempt on another theory.4
The result reached by the Tax Court in Hartland Associates and in this case makes the regulation meaningless verbiage. Neither of the litigants contends that Regulation § 1.61-12(a) is invalid.5 It is our duty to effectuate its intent. To hold, as do my brethren, that it is “merely . . . the Commissioner’s interpretation of the statutes, which is not binding on us and with which we do not agree,” is to ignore the legal effect of regulations adopted by the Commissioner under the Internal Revenue Code and long continued without substantial change. See, e.g., Green v. United States, 5 Cir. 1972, 460 F.2d 412, 417 n. 4. I would therefore reverse the Tax Court on the issue concerning cancellation of accrued interest and hold the corporations liable for tax on that amount.

. This is not the same treatment normally accorded a contribution to capital; when a taxpayer receives a capital contribution, it does not usually gain a tax deduction thereby.

. The Tax Court rejected the Commissioner’s contention that, if the forgiven indebtedness was not recognizable income to the corporation, it was includable in the gross income of Mr. Hunt. Although this issue was also appealed, the Commissioner subsequently abandoned the claim.

. See, e.g., Treasury Regulations 62, Art. 50 (1921); Treasury Regulations 65, Art. 49 (1924); Treasury Regulations 69, Art. 49 (1926); Treasury Regulations 74, Art. 64 (1928); Treasury Regulations 77, Art. 64 (1932); Treasury Regulations 86, Art. 22(a)-14 (1934); Treasury Regulations 94, Art. 22(a)-14 (1936); Treasury Regulations 101, Art. 22(a)-144 (1938).

. One commentator has suggested that Hart-land Associates makes sense only if the can-celled interest — on which the corporation was not taxed — was included in the income of the shareholders. I would, of course, agree that “[wjhere an item of corporate expense is accrued but unpaid, its later forgiveness by a shareholder should not result in income to the corporation under the tax benefit rule where the shareholder, or someone from whom the shareholder has acquired the claim, has included the item in income.” O’Hare, Statutory Nonrecognition of Income and the Overriding Principle of the Tax Benefit Rule in the Taxation of Corporations and Shareholders, 27 Tax L.Rev. 215, 241, 243 (1972). See, e.g., Carroll-McCreary Co. v. Commissioner, 2 Cir. 1941, 124 F.2d 303.
In the absence of recognition by the individual shareholders forgiving accrued interest, sound fiscal policy demands that the company disgorge the tax benefit it previously received in the expectation that the tax burden would fall elsewhere. See Note, Cancellation of Indebtedness and its Tax Consequences: I, 50 Colum.L.Rev. 1326, 1359 (1940); see generally Note, Discharge of Indebtedness and the Federal Income Tax, 53 Harv.L.Rev. 977, 995-97 (1940); Surrey, The Revenue Act of 1939 and the Income Tax Treatment of Cancellation of Indebtedness, 49 Yale L.J. 1153 (1940).

. I do not consider the addition of 26 U.S.C. § 118 by the Internal Revenue Code of 1954 to be an implicit rejection of the tax benefit rule for corporate recoveries of accrued interest owed to shareholders, as Putoma suggests. Indeed, Congress knew that the Commissioner had, since 1938, interpreted the term “contribution to capital” as excluding the interest portion of a corporate debt. Had Congress found this interpretation unpalatable, it was free to define the term differently in the statute itself. It can, with some cogency, be argued that, in the absence of authoritative appellate decision construing the statute, Congress saw no need to deal with the regulation. However, the point is not that Congress implicitly indorsed the regulation,' but that it certainly has not rejected it.