119 T.C. No. 2
UNITED STATES TAX COURT
METRO LEASING AND DEVELOPMENT CORPORATION, EAST BAY CHEVROLET COMPANY, A CORPORATION, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent*
Docket Nos. 8054-99. Filed July 17, 2002.
In an earlier opinion, we decided that P permitted its 1995 earnings to accumulate beyond the reasonable needs of its business. Secs. 531-537, I.R.C. There remains, however, a dispute concerning the computation of the accumulated earnings tax. P contends, alternatively, that R failed to reduce P’s accumulated earnings tax base by the following amounts: (1) “Deferred” tax attributable to installment sale proceeds to be received by P in tax years after 1995; (2) the amount of the income tax deficiency determined by respondent which remains contested by P and for which P has made payment after filing its petition; and (3) the difference between the amount of tax liability reported on P’s return and the amount of tax that would have been due on P’s net capital gain.
* This Opinion supplements a previously released opinion: Metro Leasing & Dev. Corp., East Bay Chevrolet Co., A Corporation v. Commissioner, T.C. Memo. 2001-119. - 2 -
All three reductions proposed by P require our interpretation of sec. 535(b), I.R.C. Proposed reductions (1) and (2) involve the interpretation of sec. 535(b)(1), I.R.C., and sec. 1.535-2(a)(1), Income Tax Regs. Reduction (3) involves sec. 535(b)(6), I.R.C. Reductions (1) and (3) present questions of first impression. With respect to reduction (2), this Court’s decision on the issue was reversed by the Court of Appeals for the Fifth Circuit in J.H. Rutter Rex Manufacturing Co. v. Commissioner, 853 F.2d 1275 (5th Cir. 1987), revg. on this point T.C. Memo. 1987-296. If we follow the holding of the Court of Appeals, P would be entitled to a reduction for the paid, but still contested, income tax deficiency. R urges this Court not to follow the holding of the Court of Appeals. Held: This Court will not follow the holding of Court of Appeals on this point in Rutter Rex. Held, further, sec. 535(b), I.R.C., and underlying regulations are interpreted, and R’s computation of P’s accumulated earnings tax liability is correct.
William L. Raby, for petitioner.
Kathryn K. Vetter, for respondent.
SUPPLEMENTAL OPINION1
GERBER, Judge: In an earlier opinion, we decided that
petitioner permitted its 1995 earnings to accumulate beyond the
1 On May 18, 2001, this Court filed a Memorandum Findings Of Fact And Opinion, Metro Leasing & Dev. Corp., East Bay Chevrolet Co., A Corporation v. Commissioner, T.C. Memo. 2001-119, in two consolidated cases (docket Nos. 8054-99 and 8055-99) stating that decisions would be entered pursuant to Rule 155 of the Court’s Rules of Practice and Procedure in both docket numbers. On Sept. 20, 2001, in docket No. 8055-99, Respondent’s Computation For Entry Of Decision (together with a proposed decision document) was filed. On Oct. 3, 2001, by order of this Court, the consolidated cases at docket No. 8054-99 and docket No. 8055-99 were severed. On Oct. 5, 2001, a decision was entered in docket No. 8055-99. - 3 -
reasonable needs of its business. See secs. 531-537;2 Metro
Leasing & Dev. Corp. v. Commissioner, T.C. Memo. 2001-119. We
also decided the amount of reasonable compensation for
petitioner’s officers. To reflect our holding and to adjust for
agreed items, the parties were required to compute the amount of
resulting income tax and accumulated earnings tax liabilities
pursuant to Rule 155 computation procedures.
The parties, in docket No. 8054-99, disagree about the
computation of the accumulated earnings tax liability. That tax
liability is computed by applying the accumulated earnings tax
rate to a corporation’s accumulated taxable income. Accumulated
taxable income is computed by making certain adjustments to
taxable income. Respondent computed a proposed accumulated
earnings tax liability of $56,248, and petitioner disagreed,
contending that three additional adjustments should be made to
respondent’s computation. If any of petitioner’s proposed
adjustments are sustained, the resulting accumulated earnings tax
liability would be within a range of amounts from zero to
$51,074.
Petitioner argues that, in computing accumulated taxable
income, respondent failed to reduce taxable income by the
2 All section references are to the Internal Revenue Code in effect for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated. - 4 -
following items: (1) Income tax attributable to unrealized and
unrecognized installment sale proceeds (if correct, this
adjustment would result in no accumulated earnings tax
liability); (2) the amount of the income tax deficiency either
determined by respondent or decided by this Court (resulting in
no liability or $13,666 in accumulated earnings tax,
respectively); and (3) an increased reduction under section
535(b)(6), if any accumulated earnings tax liability results
after our consideration of proposed adjustments (1) and (2).
I. Tax Liability on Installment Sale Income To Be Received in Years After 1995
Section 531 imposes a tax on a corporate taxpayer’s
accumulated taxable income. Accumulated taxable income is
computed by making certain adjustments to a corporate taxpayer’s
taxable income. Sec. 535(a). In particular, section 535(b)(1)
permits a deduction for Federal income tax “accrued during the
taxable year”. In approaching this deduction, petitioner argues
that its tax liability on unrealized and unrecognized installment
sale income had accrued. This issue is one of first impression
in the context of computing accumulated taxable income.
During its 1995 tax year, petitioner sold improved real
property. The gross profit from the sale was $1,569,211. - 5 -
Petitioner reported the sale under the installment method.3
Under that method, a taxpayer reports the taxable portion of each
installment in the year received. Petitioner received $28,376 in
installments for 1995, of which only $20,303 was included in
income by petitioner on its 1995 Federal income tax return.
Petitioner “deferred” the inclusion in income of the remainder of
the $1,569,211 installment sale gross profit until future
installments were paid/received.4
In arguing that the tax on future installment income had
“accrued”, petitioner relies on section 1.535-2(a)(1), Income Tax
Regs. That regulation contains the following elaboration on the
deduction as being “for taxes accrued during the taxable year,
regardless of whether the corporation uses an accrual method of
accounting, the cash receipts and disbursements method, or any
other allowable method of accounting.”
3 Petitioner’s 1995 Federal return contains the notation that it uses the accrual method of accounting for tax purposes. With respect to the real estate sale, however, petitioner elected the installment method. 4 Petitioner reflected an amount in excess of $500,000 in connection with the installment sale as “deferred income taxes” (a current liability) on the balance sheet which was part of its 1995 return. In addition, for financial reporting purposes, petitioner included the “deferred” installment sale income in its 1995 income. However, no part of the income that may be realized from subsequent years’ installments was included in petitioner’s 1995 Federal income tax base. - 6 -
According to petitioner, the quoted phrase changes all
taxpayers’ methods of reporting income for purposes of section
535(b)(1) to the accrual method. Petitioner contends that the
phrase “regardless of whether the corporation uses an accrual
method of accounting, the cash receipts and disbursements method,
or any other allowable method of accounting” modifies the
statutory phrase “taxes accrued during the taxable year”. In
other words, petitioner argues that the taxes that accrued during
the 1995 year should include future years’ installment sale
income as though petitioner had reported the entire sale under
the accrual method for 1995. Computing the accrued tax in the
manner proposed by petitioner would result in no accumulated
taxable income and, therefore, no accumulated earnings tax
liability.
Respondent disagrees with petitioner and points out that the
language of section 1.535-2(a)(1), Income Tax Regs., was not
intended to change petitioner’s method for reporting income from
the installment to the accrual method. In that regard,
respondent contends that section 535(b)(1) and the underlying
regulation concern the amount of tax that “accrued during the
taxable year”. Respondent also contends that petitioner’s post-
1995 installment sale income does not meet the well-established
standard for accrual of the income and/or tax during petitioner’s
1995 Federal tax year. - 7 -
We agree with respondent. The regulation permits petitioner
to deduct its tax liability which had accrued but had not been
paid by the end of 1995. The regulation does not change
petitioner’s tax accounting method for reporting income.
Respondent’s interpretation of the regulation would result in
equal treatment for corporate taxpayers with respect to the
accrual of a tax liability for the year(s) under consideration.5
Petitioner’s interpretation, for purposes of computing
accumulated taxable income, would place all taxpayers on the
accrual method for reporting income.6
We find petitioner’s approach to be inherently inconsistent
with and contradictory to the statutory scheme, especially when
considered in the factual context of this case. In that regard,
petitioner seeks the benefit of a reduction attributable to tax
on unrealized installment sale income in computing accumulated
5 For example, under the cash method a taxpayer’s tax liability would not be deductible until such time as it is paid. Under respondent’s interpretation, a cash basis taxpayer would be entitled to deduct unpaid, but established (“accrued”), income tax liability that, but for payment, had accrued during the taxable year. 6 Under petitioner’s interpretation of the statute, its sales transaction would have to be treated as an accrual method transaction as though the installment reporting method had not been elected. - 8 -
taxable income. Petitioner, however, has not included any
portion of that same income in its tax base for 1995.7
Petitioner’s interpretation of the subject regulation does
not comport with the section 535 statutory phrase “accrued during
the taxable year”. In addition, the modification of a taxpayer’s
overall tax accounting method does not appear to fit within the
regimen of section 535(b). “The adjustments prescribed by
section 535(a) and (b) are designed generally to assure that a
corporation’s ‘accumulated taxable income’ reflects more
accurately than ‘taxable income’ the amount actually available to
the corporation for business purposes.” Ivan Allen Co. v. United
States, 422 U.S. 617, 626 (1975).
The adjustments provided for in section 535(b) increase or
decrease taxable income, on an annualized basis, to arrive at a
base against which to apply the accumulated earnings tax of
section 531. For example, section 535(b)(1) provides for a
reduction for taxes accrued during the taxable year and section
535(b)(4) requires that net operating loss deductions from other
7 For example, if petitioner had included the income in its tax base for 1995, its taxable income (the starting point for computing accumulated taxable income) would have been proportionately larger and, even after the reduction for the “accrued tax” on future installment income, would have had the potential to result in a larger accumulated earnings tax than the $56,248 computed by respondent. In effect, petitioner seeks to reduce the accumulated taxable income base by the future tax liability without including the future income in the income accumulation for the 1995 tax year. - 9 -
years must be added back. The purpose of these adjustments is to
find the amount by which income has been allowed to accumulate
beyond the needs of the business for a particular tax year.
Respondent’s interpretation of the regulatory phrase accomplishes
that end. Petitioner’s interpretation, on the other hand,
addresses the question of future tax liability.8
Under established tax accounting principles for accrual, a
liability is incurred and/or taken into account in the year in
which all the events have occurred that establish the fact of the
liability. See sec. 1.461-1(a)(2), Income Tax Regs. All the
events have occurred when the amount of the liability can be
determined with reasonable accuracy and economic performance has
occurred with respect to the liability. Id. All of the events
have not occurred with respect to petitioner’s tax liability on
future years’ installment sale income. Accordingly, petitioner
is not entitled to deduct tax on post-1995 installment sale
income from taxable income in arriving at accumulated taxable
income for 1995.
8 To the extent that petitioner receives installment income in future years, the tax and income would be matched in the same taxable year and have a direct bearing on whether that income was allowed to accumulate beyond its needs for that future year. - 10 -
II. Whether a Contested Income Tax Deficiency That Has Been Paid Is Deductible From Taxable Income in Arriving at Accumulated Taxable Income
Here again, we focus on section 535(b)(1) and the underlying
regulation in considering whether a contested income tax
deficiency is a tax that “accrued during the taxable year”.
Petitioner reported an income tax liability of $2,674 on its 1995
corporate Federal income tax return. The $2,674 was remitted by
petitioner during March 1996, when it filed its 1995 return.
Thereafter respondent determined a deficiency in petitioner’s
income tax and, in addition, that petitioner was subject to the
accumulated earnings tax. After the petition was filed and
before we issued our opinion, petitioner tendered payment of the
income tax deficiency to respondent. Although petitioner
tendered payment, it continues to contest the income tax
deficiency. The parties disagree with respect to whether any
part of the income tax deficiency should be deducted from taxable
income to arrive at accumulated taxable income, the base for the
accumulated earnings tax.
In making the adjustments to taxable income to arrive at
accumulated taxable income, respondent deducted the $2,674 tax
liability reported by petitioner, even though the $2,674 was not
paid until after the close of the 1995 tax year. In addition to
the $2,674, petitioner argues that the income tax deficiency,
either in the amount determined by respondent or decided by the
Court, should also be deducted from taxable income to reduce the - 11 -
accumulated earnings tax base.9 Respondent disagrees, contending
that the income tax deficiency did not accrue during the taxable
year as required by section 535(b)(1) because petitioner
continues to contest it. In support of his argument, respondent
relies on the well-established standards for accrual (the “all
events test”), contending that a contested tax liability does not
meet that test.
Petitioner relies on the holding in J.H. Rutter Rex
Manufacturing. Co. v. Commissioner, 853 F.2d 1275 (5th Cir.
1988), revg. T.C. Memo. 1987-296 (Rutter Rex).10 The rationale
of that case focuses on the word “unpaid” in section 1.535-
9 A taxpayer’s Federal income tax liability is not deductible in arriving at taxable income. See sec. 275. A Federal income tax liability that “accrued during the taxable year” is allowed as a deduction from the tax base for the accumulated earnings tax. See sec. 535(b)(1). 10 Our J.H. Rutter Rex Manufacturing Co. v. Commissioner opinion (T.C. Memo. 1987-296) (Rutter Rex) was reversed during 1988 (Rutter Rex, 853 F.2d 1275 (5th Cir. 1988). We consider in this opinion whether we will follow the holding of the Court of Appeals for the Fifth Circuit or adhere to our established holding on this question. Since the reversal, this point has not been addressed by this Court or any other court. Any appeal of our decision in these consolidated cases would normally lie with the Court of Appeals for the Ninth Circuit because petitioner’s principal place of business was in California. See sec. 7482(b)(1)(B). The Court of Appeals for the Ninth Circuit has not addressed the question we consider here. Even though this Court may disagree with an appellate court holding that is squarely on point, we shall follow the appellate court holding if that court is the venue for appeal. See Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971). - 12 -
2(a)(1), Income Tax Regs.,11 to reach the conclusion that a
contested12 income tax deficiency that has been paid is
deductible within the meaning of section 535(b)(1). Rutter Rex,
supra at 1296. We note that the Court of Appeals for the Fifth
Circuit did not invalidate section 1.535-2(a)(1), Income Tax
Regs., in the process of reaching its holding. The factual
predicates for the taxpayer in Rutter Rex and petitioner are
substantially identical.13
11 The word “unpaid” appears in the last sentence of the pertinent part of sec. 1.535-2(a)(1), Income Tax Regs., as follows:
for taxes accrued during the taxable year, regardless of whether the corporation uses an accrual method of accounting, the cash receipts and disbursements method, or any other allowable method of accounting. In computing the amount of taxes accrued, an unpaid tax which is being contested is not considered accrued until the contest is resolved.
(Emphasis supplied.) 12 In its opinion, the Court of Appeals acknowledged that the income tax deficiency remained in controversy, even though payment had been proffered. Accordingly, the Court was aware that, ultimately, the taxpayer’s accumulation might not have been subjected to the contested tax deficiency. 13 The taxpayer in Rutter Rex petitioned this Court to contest income and accumulated earning tax deficiencies determined by the Commissioner. After the filing of the petition and this Court’s opinion as to the amount of the income tax deficiency, but prior to the final computation of the accumulated earning tax and the entry of a decision, the taxpayer “apparently offered to pay” the contested income tax deficiencies. See Rutter Rex, 853 F.2d at 1295. We surmise from the quoted language that the deficiency under consideration in Rutter Rex had not been assessed. Likewise, in the case we consider, (continued...) - 13 -
The Court of Appeals for the Fifth Circuit emphasized in its
rationale
that the accumulated earnings tax is a penalty tax and thus is to be strictly construed. Ivan Allen Co., 422 U.S. at 626, 95 S. Ct. at 2506. Due to the special nature of the accumulated earnings tax and its focused examination of earnings accumulated in a given year, it would be inequitable and inconsistent not to allow a corporation to deduct taxes assessed and attributable for the year at issue, even though the corporation may be contesting the taxes, as long as the corporation has paid the taxes prior to the final computation of its accumulated earnings tax liability. * * * [Rutter Rex, supra at 1296.]
We respectfully disagree with the interpretation of the
Court of Appeals for the Fifth Circuit of section 1.535-2(a)(1),
Income Tax Regs. That regulation, in its amplification of the
language “tax accrued during the taxable year”, is designed to
permit a reduction from taxable income in arriving at accumulated
taxable income for a tax liability that had accrued during the
taxable year, but had not been paid (is “unpaid”). That final
caveat of the regulation simply explains that an accrued but
unpaid tax liability may not be used to reduce the base for the
accumulated earnings tax, if the tax is contested. The focus of
that final caveat is that no deduction is permissible where the
liability is contested. The Court of Appeals, however,
13 (...continued) respondent’s computation reflects that petitioner’s payment, in the amount of $326,932, had been paid but not assessed. - 14 -
interpreted the term “unpaid” as the focus of the regulation’s
caveat and its controlling condition.
Petitioner argues that the result fashioned by the Court of
Appeals in Rutter Rex is more equitable. We observe, however,
that it is inconsistent in that it treats a paid but contested
deficiency differently from one that is unpaid and contested. In
either situation, there is no way to know whether a taxpayer’s
earnings will ultimately bear the burden of the contested
deficiency determination. The payment of a contested income tax
deficiency does not overcome the requirement that the obligation
be fixed or final for accrual.14
Petitioner argues that traditional accrual concepts (“all
events test”) should not be employed for determining income tax
accrued in the computation of accumulated taxable income.
Petitioner’s argument is based on the appellate court’s rationale
in Rutter Rex that it would be inequitable to prohibit a
reduction for a paid, but contested, tax deficiency. Petitioner,
however, has not provided a policy reason to treat taxpayers who
14 In addition, from the perspective of the accumulated earnings tax, payment of a contested income tax deficiency some 5 or 6 years after the accumulation in question would appear to have little relevance to the question of whether the tax “accrued during the taxable year” or whether a taxpayer allowed its income to accumulate beyond the reasonable needs of the business. The quoted statutory language and the regimen of the accumulated earnings tax address the proscribed accumulation at the time of the accumulation. - 15 -
contest an unpaid income tax deficiency differently from
taxpayers who choose or are able to pay a contested deficiency.
Our holding in Rutter Rex, T.C. Memo. 1987-296, was
consistent with our holding in Doug-Long, Inc. v. Commissioner,
73 T.C. 71 (1979), which, in turn, followed the Supreme Court’s
reasoning in Dixie Pine Prods. Co. v. Commissioner, 320 U.S. 516
(1944), and related precedent. See also Estate of Goodall v.
Commissioner, 391 F.2d 775 (8th Cir. 1968). Those cases follow
traditional accrual principles holding that a contested tax
liability is not deductible because it has not accrued.
In Doug-Long, Inc. v. Commissioner, supra, we held that the
questioned phrase in the regulation was a valid interpretation of
section 535 when determining a corporation’s Federal income tax
that had accrued during the taxable year. The Commissioner has
also provided guidance on this point, consistent with his
position that contested deficiencies may not be reduced from the
accumulated earnings tax base. See Rev. Rul. 72-306, 1972-1 C.B.
166. Moreover, the rationale employed in the Rutter Rex
appellate opinion rests upon perceived inequities and varies from
the requirements of section 461(f) and traditional accrual
principles.15 In that regard, the Court of Appeals for the
15 The Court of Appeals for the Fifth Circuit, in a footnote, also acknowledged that their holding was contrary to cases interpreting the phrase “taxes * * * accrued during the taxable year” in the context of personal holding tax cases under (continued...) - 16 -
Eighth Circuit, relying on Dixie Pine Prods. Co. v. Commissioner,
320 U.S. 516 (1944), held that the all events test applied in
deciding “what may be regarded as Federal income taxes of the
corporation properly ‘paid or accrued during the taxable year’”.
Estate of Goodall v. Commissioner, supra at 800.
Significantly, Congress in section 535(b) has specifically
provided for adjustments that cause the accumulated earnings tax
to be applied or not to be applied to various items. There is no
indication that Congress intended that the term “accrual” have a
different meaning for purposes of section 535(b) and section
1.535-2(a)(1), Income Tax Regs., than its traditional and well-
established meaning. In that context, we interpret the last line
of section 1.535-2(a)(1), Income Tax Regs., as simply explaining
that an accrued but unpaid tax liability may not be used to
reduce the base for the accumulated earnings tax, if the tax is
contested.16 Accordingly, in a situation where a taxpayer
15 (...continued) secs. 541-547, a companion penalty regimen. See LX Cattle Co. v. United States, 629 F.2d 1096 (5th Cir. 1980); Kluger Associates, Inc. v. Commissioner, 617 F.2d 323 (2d Cir. 1980), affg. 69 T.C. 925 (1978); Hart Metal Prods. Corp. v. Commissioner, 437 F.2d 946 (7th Cir. 1971), affg. T.C. Memo. 1969-164; Mariani Frozen Foods, Inc. v. Commissioner, 81 T.C. 448 (1983), affd. sub nom. Gee Trust v. Commissioner, 761 F.2d 1410 (9th Cir. 1985). For additional discussion by the Court of Appeals on this point, see Rutter Rex, 853 F.2d at 1297 n.37. 16 Although not decisive, it is interesting to note that in the context of a prepayment forum, the income tax deficiency is not assessed and, as a technical matter, could not be paid. By (continued...) - 17 -
contests the Commissioner’s determination and may continue to
contest it after our decision is entered, the “all events test”
has not been met. Our prior holdings and those of the Supreme
Court support that result.
For those reasons, we disagree with the holding and
rationale of the Court of Appeals for the Fifth Circuit and
continue to adhere to our established precedent. We hold that no
part of petitioner’s paid, but contested, income tax deficiency
should be reduced from its taxable income in arriving at
accumulated taxable income under section 535(b)(1).
III. Whether the Amount of the “Tax Attributable” Adjustment to Capital Gains That Is Used To Arrive at the Accumulated Earnings Tax Base Should Be Limited to Petitioner’s Reported Tax Liability for the Year
Petitioner argues, as its third and final alternative, that
respondent’s computation of the adjustment for capital gains is
understated. Petitioner argues that the tax attributable
adjustment should be limited to the actual overall tax liability
reported or a duplication of tax burden would result. Respondent
contends that his adjustment follows the literal requirements of
section 535(b)(6)(A).
16 (...continued) contesting the deficiency, a taxpayer ensures that the tax may not be assessed or collected. Even though a deficiency is paid after the filing of a petition, if a taxpayer continues to contest it, the tax is not assessed. Normally, payment during the course of a prepayment (deficiency) forum is used to stop the running of interest and is treated more like a deposit should an income tax deficiency be ultimately decided. - 18 -
Section 535(b)(6)(A) provides for a deduction from taxable
income in arriving at accumulated taxable income of “the net
capital gain * * * reduced by * * * the taxes attributable to
such net capital gain.” Section 535(b)(6)(B) defines “the taxes
attributable to the net capital gain” as the difference between
“the taxes imposed by this subtitle (except the tax imposed by
this part) for the taxable year, and * * * such taxes computed
for such year without including in taxable income the net capital
gain for the taxable year”.
The section 535(b)(6)(B)(i) language “the taxes imposed by
this subtitle”, is the focus of the parties’ dispute. Petitioner
contends that the “taxes imposed” should be limited to the amount
of tax liability it reported on its 1995 return or $2,674. On
the other hand, respondent’s computation is based on “taxes
imposed” of $110,203, the amount of income tax this Court decided
is imposed under the statute.
In applying the above-quoted adjustment in his Rule 155
computation, respondent computed the accumulated earnings tax as
follows:17
17 There appear to be two errors in respondent’s computation of petitioner’s accumulated earnings tax. First, there appears to be an error in subtraction. If $325,000 is reduced by $2,674 and $24,616, the result should be $297,710 and not $300,384. Second, the amount shown as taxable income on Form 5278, Statement--Income Tax Changes, of respondent’s computation is $325,522 and not $325,000. The parties will be asked to address these apparent discrepancies in a Rule 155 computation to be prepared in accord with this Supplemental Opinion. - 19 -
Accumulated Earnings Tax-1995
Taxable income per Form 5278 $325,000 Less sec. 535(b) adjustments: 1. Federal income taxes accrued (2,674) 2. Net capital gains 40,354 less: income tax attribu- table thereto 15,738 (24,616) 300,384 Less dividends paid: Compensation treated as dividend (150,250) Other expenses paid for benefit of shareholders (8,094)
Accumulated taxable income 142,040
x 39.6% 56,248
In the above computation, respondent has interpreted section
535(b)(6) to mean that the net capital gain should first be
reduced by the full amount of tax on the capital gain and that it
is not limited by the amount of combined tax liability reported
by petitioner for 1995. Accordingly, respondent has taken the
net capital gain of $40,354, applied the 35-percent maximum rate
under section 1201 and arrived at $15,738 of income tax
attributable to the net capital gain.18 After making the “tax
attributable” adjustment, respondent reduced taxable income by
the $24,616 difference in the process of arriving at accumulated
taxable income.
18 We note that petitioner reported $35,884 of net capital gain and that respondent made adjustments increasing the amount to $40,354. We also note that 35 percent of $40,354 is $14,123.90 ($14,124) and not $15,738. It appears that another adjustment was combined with the one discussed herein, resulting in the $15,738 amount. - 20 -
Petitioner argues that if the “total amount of Federal
income tax attributable to the year 1995 for purposes of the
section 535(b)(1) calculation is determined to be $2,674, * * *
then the total amount of income tax attributable to the capital
gain cannot logically exceed $2,674.” In other words, petitioner
contends that respondent’s net capital gain deduction from
taxable income in the process of arriving at accumulated taxable
income is $13,064 too small.19
The question raised by petitioner’s argument is whether the
amount of tax, in the context of the section 535(b)(6) phrase tax
“attributable to the net capital gain”, is limited by the amount
of a taxpayer’s total combined income tax liability20 that was
reported for the year. This is a question of first impression.
In order to understand better the distinctions between the
parties’ positions, we review petitioner’s 1995 Form 1120, U.S.
Corporation Income Tax Return. Petitioner reported “Total
Income” of $898,479, of which $35,884 was reported as “Capital
gain net income”. The remainder of the income reported appears
to be from sources of “ordinary income”, such as rents,
royalties, etc. After ordinary deductions of $844,327 and a
19 In support of its position, petitioner argues that respondent’s approach results in a duplication or “doubling-up of the tax element”. Essentially, respondent’s computation results in removing the capital gain and its tax effect from the tax base for computing accumulated earnings tax. 20 The liability when considering both ordinary and net capital gain income. - 21 -
$36,326 net operating loss deduction, petitioner reported taxable
income of only $17,825.
The $17,825 of taxable income reported by petitioner
resulted in a $2,674 tax liability. It is that $2,674 which
petitioner argues should limit the “tax attributable” to net
capital gains within the meaning of section 535(b)(6). We note
that the $2,674 of tax liability reported by petitioner has
already been deducted from taxable income in the process of
arriving at accumulated taxable income.21
The problem with petitioner’s position is that $2,674 is not
the “tax imposed” on petitioner’s 1995 taxable income. The tax
imposed on petitioner’s 1995 taxable income is $110,203, the
amount decided by this Court in our earlier opinion Metro Leasing
& Dev. Corp. East Bay Chevrolet Co. v. Commissioner, T.C. Memo.
2001-119, which concerned the underlying tax issues. The
$110,203 amount decided by this Court is the tax imposed under
section 535(b)(6)(B)(i). If $110,203 is used as the tax imposed
in the section 535(b)(6) calculation, respondent’s computation of
accumulated taxable income is correct.
Section 535(b) contains several adjustments, some of which
are intended to remove certain items from the accumulated
earnings tax base. In that regard, section 535(b)(5),(6), and
(7) provides for adjustments pertaining to capital gains. In
21 That adjustment was made under sec. 535(b)(1) as discussed earlier in this Opinion. - 22 -
general, section 535(b)(5) permits a reduction for net capital
losses for the taxable year. Section 535(b)(6) provides for a
reduction for net capital gains, less tax attributable to said
gains. Finally, section 535(b)(7) makes inapplicable the
ordering rules for capital losses under section 1212 and provides
for the carryover of the prior year’s net capital loss.
The net effect of the provisions regarding capital gains and
losses is to remove them from the accumulated earnings tax base,
irrespective of whether they resulted in gain or loss.
Respondent has removed the net capital gains in accord with the
statute. The limitation argued for by petitioner does not
comport with the statute, because the amount of tax liability
reported by petitioner is not, ultimately, the “tax imposed” by
the statute.
A similarly worded adjustment and computation for removing
net capital gains from the computation of the personal holding
company tax is provided for in section 545(b)(5). Like the
accumulated earnings tax, the personal holding tax is considered
a “penalty” tax. Taxpayers, in the context of the personal
holding tax, have made arguments similar to those made by
petitioner in this case. They argued that the tax imposed should
equal the tax accrued for purposes of the capital gain
adjustment. This Court rejected those arguments, holding that
Congress was aware that taxpayers would not be able to deduct - 23 -
contested taxes in connection with the adjustment for “taxes
accrued during the year”, whereas the tax imposed would include
the deficiency decided by a court. See Kluger Associates, Inc.
v. Commissioner, 69 T.C. 925, 940-941 (1978), affd. 617 F.2d 323,
333 (2d Cir. 1980); Ellis Corp. v. Commissioner, 57 T.C. 520, 523
(1972).
We are aware of the paradox that has been occasioned by
petitioner’s choice to continue contesting the income tax
deficiency. That choice has resulted in petitioner’s inability
to treat the income tax deficiency, decided by this Court, as
accrued during the taxable year for purposes of the section
535(b)(1) adjustment. Conversely, petitioner may not use the
$2,674 tax liability it originally reported in its computation of
the section 535(b)(6) adjustment. Although the two items are
conceptually related, by definition they are not interdependent.
For the section 535(b)(1) adjustment, the tax must have accrued.
Whereas the section 535(b)(6)(B)(i) aspect of the capital gain
adjustment is dependent upon the amount of the tax imposed. The
tax “imposed” and the tax “accrued” for a particular year could
be the same amount. But where the tax “imposed” is contested, it
is not treated as “accrued”.
We therefore hold that respondent correctly computed the
adjustment for net capital gains under section 535(b)(6) and that - 24 -
respondent’s approach to the Rule 155 computation is not in
error.
To reflect the foregoing,
Decision will be entered
under Rule 155.
Reviewed by the Court.
WELLS, COHEN, SWIFT, WHALEN, COLVIN, HALPERN, BEGHE, CHIECHI, FOLEY, VASQUEZ, GALE, THORNTON, and MARVEL, JJ., agree with the majority opinion.
RUWE and LARO, JJ., did not participate in consideration of this case. - 25 -
HALPERN, J., concurring: Although I have joined in the
majority’s opinion, I write separately to set forth more fully
why I believe petitioner may not accrue the contested tax
liability in question.
I. Application of the All Events Test
The majority notes: “Our holding in J.H. Rutter Rex
Manufacturing Co. v. Commissioner, T.C. Memo. 1987-296, was
consistent with our holding in Doug-Long, Inc. v. Commissioner,
73 T.C. 71 (1979), which, in turn, followed the Supreme Court’s
reasoning in Dixie Pine Prods. Co. v. Commissioner, 320 U.S. 516
(1944), and related precedent.” Majority op. p. 15. It is upon
Dixie Pine Prods. Co. and the “related precedent” that I wish to
focus.
The seminal case establishing the basic rule for when a
liability is incurred and, thus, is taken into account under the
accrual method of accounting for Federal income tax purposes is
United States v. Anderson, 269 U.S. 422 (1926), which holds that
a liability is incurred in the year in which occur all the events
needed to create an unconditional obligation to pay such
liability. That test (the all events test) is now embodied in
section 1.446-1(c)(1)(ii)(A), Income Tax Regs., which provides
that, under an accrual method of accounting (in addition to the
requirement of “economic performance”, added in 1984), a
liability is incurred for income tax purposes “in the taxable - 26 -
year in which all the events have occurred that establish the
fact of the liability, [and] the amount of the liability can be
determined with reasonable accuracy”. See also sec. 1.461-
1(a)(2), Income Tax Regs.
In Dixie Pine Prods. Co. v. Commissioner, supra, the Supreme
Court amplified the all events test by holding that all of the
events to establish a liability have not occurred if the
liability is contingent and is contested by the supposed obligor.
Id. at 519; accord Security Flour Mills Co. v. Commissioner, 321
U.S. 281 (1944).1 In Dixie Pine Prods. Co. v. Commissioner,
supra, the taxpayer had contested a State excise tax that,
otherwise, would have been due for the taxable year in question.
The Supreme Court held that the taxpayer could claim a deduction
only for the taxable year in which its liability for the tax was
finally settled. Id. at 519.
In United States v. Consol. Edison Co., 366 U.S. 380 (1961),
the Supreme Court applied the all events test to a situation in
which a contested real estate tax liability was paid in order to
1 It should be noted that, in the absence of a contest, the all events test is satisfied with respect to the additional tax attributable to an income tax deficiency as of the close of the deficiency year. See Dravo Corp. v. United States, 172 Ct. Cl. 200, 348 F.2d 542 (1965) (additional State capital stock tax paid without protest by accrual method taxpayer in year 3 with respect to year 1 properly accruable for year 1). Such additional tax is, therefore, properly accruable for the deficiency year under sec. 535(b)(1). Rev. Rul. 68-632, 1968-2 C.B. 253. - 27 -
stay the seizure and sale of the property (in satisfaction of the
tax lien) during the pendency of the contest. The Court held
that such payment did not satisfy the all events test so long as
the contest was still pending. Id. at 391-392.
The result in United States v. Consol. Edison Co., supra,
was overruled (retroactively to the effective date of the 1954
Code) by section 223 of the Revenue Act of 1964, Pub. L. 88-272,
78 Stat. 19, 76, which added section 461(f), which permits a
deduction for contested items in the year of payment, even though
the contest is not resolved until a later year. S. Rept. 830,
88th Cong., 2d Sess. (1964), 1964-1 C.B. (Part 2) 505, is the
report of the Committee on Finance that accompanied H.R. 8363,
88th Cong., 1st Sess. (1963), which, when enacted, became the
Revenue Act of 1964. The report explains the general reasons for
section 461(f) (which originated in the Senate) as follows:
Although your committee does not question the legal doctrine laid down by the Supreme Court in the Consolidated Edison case, it believes that it is unfortunate to deny taxpayers a deduction with respect to an item where the payment has actually been made, even though the liability is still being contested either as to amount or as to the item itself. * * *
S. Rept. 830, 88th Cong., 2d Sess. (1964), 1964-1 C.B. (Part 2)
505, 604. (Emphasis added.)
Thus, under well-established principles of tax accrual laid
down by the Supreme Court, it is clear that, for income tax
purposes, the all events test is not satisfied with respect to a
contested tax liability, and the contested tax liability may not - 28 -
be “accrued”, until the year in which the contest is terminated.
If the contested liability is paid before the contest is
terminated, the liability is deductible in the year of payment
pursuant to section 461(f). If the same tax accrual principles
apply for purposes of section 535(b)(1), there is no basis in law
for the holding of the Court of Appeals for the Fifth Circuit in
J.H. Rutter Rex Manufacturing Co. v. Commissioner, 853 F.2d 1275
(5th Cir. 1988), revg. T.C. Memo. 1987-296, that a taxpayer’s
payment of a contested tax liability entitles the payor to treat
the contested liability as “accrued” during the prior taxable
year to which the accumulated earnings tax relates.
II. Relevance of Sec. 1.535-2(a)(1), Income Tax Regs.
The Court of Appeals for the Fifth Circuit, in J.H. Rutter
Rex Manufacturing Co. v. Commissioner, supra at 1297, noted that
the last sentence of section 1.535-2(a)(1), Income Tax Regs.,
does not prohibit an accrual deduction for paid contested taxes
prior to termination of the contest because the sentence provides
only that “an unpaid tax which is being contested is not
considered accrued until the contest is resolved.” (Emphasis
added.) In reaching that conclusion, the Court of Appeals
overlooked the fact that, at the time the cited regulation was
promulgated, pursuant to T.D. 6377, 1959-1 C.B. 125, the Internal
Revenue Service’s published position with respect to paid
contested taxes was that such taxes are deductible in the year of - 29 -
payment, even though they continue to be contested. See G.C.M.
25298, 1947-2 C.B. 39, 44, which followed Chestnut Sec. Co. v.
United States, 104 Ct. Cl. 489, 62 F. Supp. 574 (1945).2 Under
those circumstances, the general accrual rule applicable to
contested taxes, contained in section 1.535-2(a)(1), Income Tax
Regs., could only have applied to unpaid taxes because its
extension to paid taxes would have been inconsistent with G.C.M.
25298. Since 1964, an extension of that provision to paid
contested taxes would be inconsistent with section 461(f), which,
in effect, codified and reinstated the Commissioner’s position in
G.C.M. 25298. Therefore, petitioner’s payment of the contested
taxes could serve only to accelerate a deduction to the year of
payment pursuant to section 461(f). There is no basis under
either the all events test or section 461(f) for the Court of
Appeals for the Fifth Circuit’s suggestion, J.H. Rutter Rex
Manufacturing Co. v. Commissioner, supra at 1297, that the
payment itself somehow justifies an accrual of such taxes in the
earlier year for which the taxpayer is subject to tax imposed by
section 531.
We are left, then, to determine whether the test of a
section 535(b)(1) tax accrual is the all events test.
2 Chestnut Sec. Co. v. United States, 104 Ct. Cl. 489, 62 F. Supp. 574 (1945), was effectively overruled by United States v. Consol. Edison Co., 366 U.S. 380 (1961). - 30 -
III. Validity of Sec. 1.535-2(a)(1), Income Tax Regs.
The final sentence of section 1.535-2(a)(1), Income Tax
Regs., reads: “In computing the amount of taxes accrued, an
unpaid tax which is being contested is not considered accrued
until the contest is resolved.” That sentence leaves little
doubt that the Secretary of the Treasury intended the test of a
section 535(b)(1) tax accrual to be the all events test. See
Doug-Long, Inc. v. Commissioner, 73 T.C. at 81 (“The last
sentence of this regulation is consistent with the definition of
accrued taxes which has been set forth in Dixie Pine Products Co.
v. Commissioner, supra; Great Island Holding Corp. v.
Commissioner, * * * [5 T.C. 150, 160 (1945)]; and sec. 1.461-
2(b)(2), Income Tax Regs.”). The only question is whether that
is a valid interpretation of the statutory command of section
535(b)(1) that, in computing accumulated taxable income, taxable
income be adjusted by subtracting certain taxes “accrued” during
the taxable year. In Doug-Long, Inc. v. Commissioner, supra at
82, we held that the last sentence of section 1.535-2(a)(1),
Income Tax Regs., validly interprets the statute. In J.H. Rutter
Rex Manufacturing Co. v. Commissioner, supra at 1296, the Court
of Appeals for the Fifth Circuit made a cogent argument that the
accumulated earnings tax, a penalty tax, should not be based on
earnings “that may not exist at all depending on the deficiency
claimed.” Taken to its logical conclusion, the Court of Appeals’ - 31 -
argument is an argument to read the term “[taxes] accrued during
the taxable year” in section 535(b)(1) as meaning “[taxes]
finally determined for the taxable year”.3 That is a rule that
Congress easily could have stated. Congress, however, used the
term “taxes accrued”, and the term “accrued” has a settled
meaning, incorporating the all events test, for Federal income
tax purposes. See, e.g., sec. 1.446-1(c)(1)(ii)(A), Income Tax
Regs. In Estate of Goodall v. Commissioner, 391 F.2d 775, 800
(8th Cir. 1968), vacating and remanding T.C. Memo. 1965-154, the
Court of Appeals for the Eighth Circuit gave precisely that
meaning to the term “accrued” in a predecessor version of section
535(b)(1). If section 535(b)(1) is not clear on its face, the
Secretary’s interpretation is permissible, since it defines a
term in a way that is reasonable in light of the legislature’s
revealed design. Chevron U.S.A., Inc. v. Natural Res. Def.
Council, Inc., 467 U.S. 837, 844 (1984).4 Although policy
3 That is, finally determined before the corporation’s liability for accumulated earnings tax becomes final. 4 Petitioner suggests that the Chevron standard of review should not apply because the accumulated earnings tax is in the nature of a penalty. Even if we were to conclude that the final sentence of sec. 1.535-2(a)(1), Income Tax Regs., is invalid on that basis, it would not necessarily follow that petitioner would be entitled to deduct from its 1995 accumulated taxable income the amount of its 1995 Federal income tax deficiency as determined by this Court. That is, if we were to invalidate the final sentence of sec. 1.535-2(a)(1), Income Tax Regs., we would still be required to interpret the meaning of the term “[taxes] accrued during the taxable year” as used in sec. 535(b)(1). In this regard, petitioner offers no support for the proposition (continued...) - 32 -
considerations may suggest a taxes-as-finally-determined rule,
the use of a commonly understood term suggests the common
meaning, and the legislature’s design, as revealed, does not
contradict such usage.5
4 (...continued) that Congress intended a taxes-as-finally-determined rule as opposed to, say, a taxes-as-actually-reported rule. 5 The Court of Appeals for the Fifth Circuit in J.H. Rutter Rex Manufacturing Co. v. Commissioner, 853 F.2d 1275, 1297-1298 (5th Cir. 1988), cites a line of cases beginning with Stern Bros. Co. v. Commissioner, 16 T.C. 295 (1951), in support of its position. Those cases uphold the accrual of contested taxes in the year in which the contested tax liability arises when computing accumulated earnings and profits for invested capital purposes under the excess profits tax imposed in World War II. Id. at 322-323. See also Estate of Stein v. Commissioner, 25 T.C. 940, 966 (1956), which extends the Stern Bros. Co. rationale to permit the accrual of contested taxes in computing earnings and profits for purposes of determining whether corporate distributions are taxable dividends or nontaxable distributions from capital. In Stern Bros. Co., we were interpreting a regulation that required an accrual basis taxpayer to subtract income and excess profit taxes “for the preceding taxable year”. That is not necessarily the same as allowing a deduction for any such taxes as are “accrued” during such preceding taxable year. Moreover, Stern Bros. Co. and its progeny, including Estate of Stein, specifically distinguish the computation of accumulated earnings and profits from the computation of taxable income, where Dixie Pine Prods. Co. v. Commissioner, 320 U.S. 516 (1944), is acknowledged to be applicable. See, e.g., Stern Bros. Co. v. Commissioner, supra at 322-323. The concept of taxable income is not so different from that of “accumulated taxable income”, upon which the accumulated earnings tax is imposed, as to make the extension of Dixie Pine Prods. Co. to the latter an unreasonable interpretation of the term “accrued” as it is used in sec. 535(b)(1). - 33 -
I conclude that section 1.535-2(a)(1), Income Tax Regs.,
validly interprets section 535(b)(1): The test of a section
535(b)(1) tax accrual is the all events test.
SWIFT, WHALEN, and MARVEL, JJ., agree with this concurring opinion.