Mandell, Solomon

Shore, Al

English

The Catholic University of America Columbus School of Law

Catholic University Law Review Volume 4 Issue 1 Article 3 1954 Arrowsmith Needs a Doctor: Suggestions for a Congressional Cure Solomon Mandell Al Shore Follow this and additional works at: https://scholarship.law.edu/lawreview Recommended Citation Solomon Mandell & Al Shore, Arrowsmith Needs a Doctor: Suggestions for a Congressional Cure, 4 Cath. U. L. Rev. 33 (1954). Available at: https://scholarship.law.edu/lawreview/vol4/iss1/3 This Notes is brought to you for free and open access by CUA Law Scholarship Repository. It has been accepted for inclusion in Catholic University Law Review by an authorized editor of CUA Law Scholarship Repository. For more information, please contact edinger@law.edu. CASE-COMMENTARROWSMITH NEEDS A DOCTOR:SUGGESTIONS FOR A CONGRESSIONAL CUREbySOLOMON MANDELL*andAL SHOREtOn November 10, 1952, the United States Supreme Court decidedthe case of Arrowsmith v. Commissioner.' The problem involved was ofgeneral interest and application, and the final decision was long awaited.The writers agree with the holding of the Court, and with the reasoninginvolved. It'does, however, give rise to a general class of inequities forwhich relief should be provided. The writers believe that this relief isup to Congress, and should be brought to the attention of the appropriateCongressional tax committees.NATURE OF THE DECISIONIn the Arrowsmith case the taxpayers, in 1937, liquidated anddivided the proceeds of a corporation which they owned. Partial distribu-tions were made in 1937, 1938, and 1939, and a final distribution wasmade in 1940. Taxpayers reported the profits obtained from this trans-action as capital gain. In 1944, a judgment was rendered against the oldcorporation. Taxpayers, as transferees, paid the judgment. On their taxreturn they deducted the loss as an ordinary loss rather than as a capitalloss. The Commissioner viewed the 1944 payment as part of the originalliquidation transaction and required its classification as a capital loss,consistent with the treatment of the original transaction as a capitalgain. The Supreme Court resolved the problem in favor of the Commis-sioner. Its position may be summed up in the following quotation:It is contended, however, that this payment which would have been a capitaltransaction in 1940 was transformed into an ordinary business transaction in1944 because of the well-established principle that each taxable year is aseparate unit for tax accounting purposes. United States v. Lewis, 340 U.S.590; North American Oil Co. v. Burnet, 286 U.S. 417. But this principle isOB.B.A., College of the City of New York 1938, LL. B., Harvard 1941; formerlywith U. S. Treasury Department and Lecturer at New York Univ. Institute of FederalTaxation.t B. S., Temple 1931, Bureau of Internal Revenue 1937-53.1344 U. S. 6 (1952).not breached by considering all the 1937-1944 liquidation transaction eventsin order properly to classify the nature of the 1944 loss for tax purposes.Such an examination is not an attempt to reopen and readjust the 1937 to1940 tax returns, an action that would be inconsistent with the annual taxaccounting principle.As stated previously, the writers agree with the reasoning of theCourt. In fact, in an article entitled "Not a Gain Again, Again andAgain", published in Taxes-The Tax Magazine, in June 1952, by oneof the present writers, the same reasoning was set forth. In that articlethe Switlik2 case was criticized and the Arrowsmith case (also called theBauer case) was urged as the correct decision and, in view of the conflict,it was anticipated "that the problem will eventually be referred to theUnited States Supreme Court for decision." Now it is decided, but thedecision creates further disturbances.IMPLICATIONS OF THE DECISION-INEQUITIESAlthough the decision is correct in principle, the Arrowsmith rulewill lead to inequities in a great variety of situations.The first case involves the factual situation of the Arrowsmith caseitself. Taxpayer reported and paid taxes on capital gains in 1938, 1939and 1940. In 1944 it had to make a repayment which, for tax purposes,is regarded as a capital loss. Under present rules the taxpayer may applythat loss against capital gains in 1944, and carry any unused balance tobe similarly applied for the next five years. Further, if taxpayer is anindividual, he may also apply the capital loss against ordinary income tothe extent of $1,000 a year for each of the six year period just described.However, what may he do where he has no capital gains during the sixyear period, and where the loss may be too large to be substantiallysatisfied at the rate of $1,000 a year for six years. For example, supposethat Arrowsmith reported a capital gain in the liquidation of $500,000.Further, suppose that in 1944 he was required to repay $100,000, andthat he had no capital gains during the next six years or, perhaps, morecapital losses. Under such circumstances he would have paid a capitalgains tax on profits of $100,000 that he never really made.In the Arrowsmith case the capital gain arose from liquidationwhich, for tax purposes, is treated under I. R. C. section 115 (c) as asale of stock. Suppose, in fact, that the gain was from an actual saleof stock. For example, taxpayer is retiring from business and sells theentire capital stock of his company. He makes a profit of $500,000 andreports it for tax purposes as a long-term capital gain. In subsequentyears he must repay, for one reason or another (e.g., fraud, misrepresenta-tion, breach of warranty, etc.), $100,000 of the proceeds of the sale2 Commissioner v. Switlik, 184 F. 2d 299 (3d Cir. 1950).of the stock. Since he then has a capital loss of $100,000, he is in theunhappy position of having no capital gains against which to take thededuction. Again he has lost the tax on $100,000. This very situationmay have arisen in the case of Duveen Brothers.8 The petitioner, in orderto sell a large block of stock which was callable at $11 per share, agreedto pay purchasers of the stock the difference between the purchase priceand the $11 redemption price. The stock was sold during the years1943 and 1944.at prices in excess of the redemption price. The stock wascalled, and the petitioner, in 1945, paid the purchasers the amountguaranteed to them. The Court held that the 1945 payment was a long-term capital loss.Since the taxpayer may not deduct the loss against the prior gain, hemust hope for future gains to get the deduction. Thus he paid tax onprofits that he didn't really make. The type of situations in which thisinequity may arise are endless. They involve just a few variables. First,there must be a transaction from which a capital gain results.The facts of the Arrowsmith and Duveen' cases are only illustrative.There may be a public issue by the insiders of a closely held corporation,or one stockholder may sell all or part of his interest to another, or anyother facts which give rise to a capital gain. Second, circumstances mustexist which give rise to a repayment in a future year, which repayment isa capital loss (per the doctrine of the Arrowsmith case). In additionto the situations previously discussed, there may be innumerable othercases leading to the same result. For example, the repayment may beoccasioned by fraudulent misrepresentations involved in the sale, and sub-sequent suit and recovery thereon. This occurred in the cases of MargeryK. Megargel' and Harwick v. Commissioner.' Or, the misrepresentationsmay exist in the absence of fraud, and yet require repayment. Or, theremay have been a mistake which later requires the seller to reimburse thebuyer. Third, the party who later sustains the capital loss must not bein a position to obtain a tax deduction or other benefit from the loss.OTHER IMPLICATIONS OF THE DECISIONNot every situation involving the doctrine of the Arrowsmith casewill result in harm or inequity. As a general rule, inequity results onlywhen the three factors mentioned in the preceding paragraph are present.For example, if the original transaction resulted in a loss and the sellersubsequently recovers additional funds, no harm is apt to result. Or, if theoriginal transaction is a gain transaction and the seller subsequently8 Duveen Brothers v. Commissioner, 17 T. C. 124 (1951), aff'd, 197 F. 2d 118 (2dCif. 1952), cert. denied, 244 U. S. 884 (1952).4 Ibid.53 T. C. 238 (1944).6133 F. 2d 732 (8th Cir. 1943).collects more monies, no harm is done. Or, if the original transaction isa loss transaction and the seller later must pay additional funds to thebuyer, the seller has not been hurt. Finally, if the basic transaction is again deal, and seller later sustains a loss through repayment, there isstill little harm to be done, if any, where the seller has capital gains inthe year of loss or subsequent years which to offset the loss.This article will not attempt to analyze the possible effects of theArrowsmith reasoning on the tax law in general. In other words, as ageneral proposition it may be interesting to explore the extent to whicha transaction in one year may be colored by facts which occurred in, aprior or later year, particularly in view of the "annual accounting con-cept" which has become fairly well fixed in our tax law. In the Arrow-smith case the conclusion of the Court was regarded by it as consistentwith the "annual accounting concept", but there may be situations whereresort to circumstances of another year to determine the character of atransaction in the taxable year may violate or threaten the "annual ac-counting concept".SUGGESTED METHODS OF RELIEFThere are several possible ways in which the aforementioned in-equities may be relieved.An obvious answer is to permit the taxpayer to carry back the lossto the year in which the profit from the basic transaction was reported,and obtain a refund. This is objectionable for several reasons. First,it will require a longer period of limitations for the right to file refundclaims. This is inconsistent with the desired policy of closing tax returnsonce and for all, as manifested by the present period of limitations.Further, the Government would undoubtedly be given the right to findoffsets against the refund. Thus a tax return could be opened manyyears after it would normally be closed by the statute of limitations.Another objection is that the legislation would be of a patchwork char-acter, and would apply to only a narrow group of cases.A second, and broader approach to the solution of this type of in-equity, as well as of other inequities, is to permit the carryback, as wellas the carryforward, of capital losses. The period of the carryback is, ofcourse, to be decided by Congress. A simple approach might be to havethe carryback for one year, as with net operating losses, since capitallosses have the same five year carryforward as net operating losses. Thusthe capital loss carryback and carryforward provisions would cover exactlythe same period as do the net operating loss carryback and carryforwardprovisions. This may not solve the problem completely, since the gaintransaction may have occurred more than one year prior to the year ofthe loss arising therefrom. However, it will be of some help and timewill tell us whether a longer carryback period is in order.This change will not merely relieve the problem discussed herein.It may also relieve a more generally disturbing situation. That is, thecase of the market trader or other businessman who makes a large capitalgain one year and then, to his surprise, loses it right back in later years.At that point he has paid taxes, and lost the use of tax dollars, onprofits that he didn't really make. Further, if he doesn't continue hisoperations, his opportunity to utilize the later capital loss may be goneforever. To that extent he may, for tax reasons, be encouraged to con-tinue a business operation against his better judgment, or to otherwiseengage in speculative operations, since he is in a position to make acapital gain at no tax cost. As indicated previously, the one year capitalloss carryback may not relieve all inequitable cases, but it should doa lot of good. Experience will teach us whether equity dictates extendingthe period of the carryback for more than one year.

Arrowsmith Needs a Doctor: Suggestions for a Congressional Cure

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Arrowsmith Needs a Doctor: Suggestions for a Congressional Cure

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