Tennessee-Carolina Transportation, Inc. v. Commissioner of Internal Revenue , 582 F.2d 378 ( 1978 )

CELEBREZZE, Circuit Judge.

The principal issue presented on appeal is whether the tax benefit rule¹ is applicable to a corporate liquidation governed by Internal Revenue Code § 336. We hold that it is and affirm the decision of the Tax Court.²

Taxpayer, Tennessee-Carolina Transportation, Inc., is a Tennessee corporation engaged in the motor freight transportation business. Pursuant to a contract entered into in 1966, taxpayer purchased in January, 1967, all of the capital stock of Service Lines, Inc. (Service). Service was also engaged in the motor freight transportation business. Service was operated temporarily as a wholly owned subsidiary of taxpayer until March 1, 1967, when it was liquidated and merged into taxpayer. The liquidation consisted of Service distributing all of its assets to taxpayer, its sole shareholder, in exchange for its stock, which was then retired.³

Among the assets distributed to taxpayer by Service were truck tires and tubes which Service had purchased for its own use. The expected useful life of these tires and tubes was approximately one year, so Service had properly fully deducted (expensed) their cost when purchased. Pursuant to Internal Revenue Code § 334(b)(2), taxpayer claimed a stepped-up basis in the assets received from Service by allocating the purchase price of the Service stock proportionately to the assets received based on their respective fair market value. Taxpayer thereafter fully deducted the amount so allocated to the tires and tubes as a business expense in the consolidated income tax return it filed with Service for 1967.⁴

The Commissioner of Internal Revenue claimed that the 1967 consolidated return underreported income.⁵ The only aspect of this determination now at issue relates to the Commissioner’s contention that the tax benefit rule required that Service include as income in 1967 the value of the tires and tubes distributed to taxpayer.⁶

The full Tax Court upheld the Commissioner’s position and found a deficiency in income taxes due from taxpayer. 65 T.C. 440 (1975).⁷ The court applied the tax benefit rule to require Service to include in its 1967 income an amount equal to the value of the previously expensed but not fully consumed tires and tubes which were distributed to taxpayer. The court rejected as “unduly restrictive” the holding in Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (9th Cir. 1963), which found the tax benefit rule inapplicable to corporate liquidations governed by § 336.

Taxpayer argues on appeal that the tax benefit rule operates only when there is a “recovery” of an amount previously deducted. It contends that Service had no “recovery” of its expense deduction for the tires and tubes since it distributed them directly to taxpayer and received nothing in exchange. We reject taxpayer’s contentions inasmuch as they would produce an unnecessary disparity between liquidations governed by § 336 and those governed by Internal Revenue Code § 337. Taxpayer’s position also asserts a wooden interpretation of the tax benefit rule which we find inappropriate.

The liquidation of Service was effected by distributing Service’s assets to its sole shareholder, taxpayer, in exchange for its stock, which was then retired. As to Service, the liquidation was thus governed by the general nonrecognition provisions of § 336.⁸ An alternative method of accomplishing the same result would have been for taxpayer to buy all of Service’s assets at the same price it paid for Service’s stock, with Service then liquidating and distributing the proceeds of the sale to its shareholders. This corporate liquidation would have been governed by the general nonrecognition provisions of § 337.⁹ The business consequences of either alternative would have been identical — Service liquidated, Service’s shareholders in possession of the proceeds of the sale in exchange for retirement of their stock, and the taxpayer in possession of Service’s assets with a basis equal to their purchase price.

Taxpayer concedes that if the liquidation of Service had been governed by § 337 the tax benefit rule would apply, overriding the general nonrecognition rule of § 337 and requiring that Service recognize as ordinary income the amount previously expensed. Anders v. United States, 462 F.2d 1147, 199 Ct.Cl. 1, cert. den. 409 U.S. 1064, 93 S.Ct. 557, 34 L.Ed.2d 517 (1972); Spitalny v. United States, 430 F.2d 195 (9th Cir. 1970); Commissioner v. Anders, 414 F.2d 1283 (10th Cir. 1969); S. E. Evans, Inc. v. United States, 317 F.Supp. 423 (W.D.Ark.1970). There is no reason in either the statute or tax policy for reaching a different result in this case merely because Service and taxpayer chose a § 336 liquidation. In a ease applying the assignment of income doctrine to overcome the general nonrecognition provisions of § 337 this court noted that § 336 and § 337 liquidations cannot always be treated alike for tax purposes due to some provisions that are unique to § 337. Midland-Ross Corp. v. United States, 485 F.2d 110, 117-18 (6th Cir. 1973).¹⁰ Midland-Ross also made it clear, however, that as a general rule § 336 and § 337 liquidations were to be treated alike. Id. at 114 (“parity of tax treatment at the corporate level”) and 117 (“purpose of establishing a parity between Sections 336 and 337”). Section 336 liquidations are to be treated like § 337 liquidations as a general rule unless some peculiar provision of § 337 justifies disparate treatment.¹¹ No such statutory justification exists here.

There is no support for the contention that § 337 was “designed to be a shield for taxpayers and not a sword to be used against them,” as contended by the dissenters here and in the Tax Court. Section 337 “was designed to eliminate the formalistic distinctions recognized and perhaps encouraged by the decisions in Court Holding and Cumberland[¹²]” Central Tablet Mfg. Co. v. United States, 417 U.S. 673, 682, 94 S.Ct. 2516, 2521, 41 L.Ed.2d 398 (1974). Taxpayer and the dissent would have us resurrect these precise formalistic distinctions.

Taxpayer seems to realize the disparity its position would sanction but nevertheless argues that the tax benefit rule is inapposite to § 336 since it cannot conceptualize any “recovery” by Service of the previously deducted amount. There are several answers to this contention.

First, there need not be an actual physical “recovery” of some tangible asset or sum in order to apply the tax benefit rule.¹³ The tax benefit rule should be applied flexibly in order to counteract the inflexibility of the annual accounting concept which is necessary for administration of the tax laws. The rule should apply whenever there is an actual recovery of a previously deducted amount or when there is some other event inconsistent with that prior deduction. See Block v. Commissioner, 39 B.T.A. 338, 340-41 (1939), aff’d sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.), cert. den. 311 U.S. 658, 61 S.Ct. 12, 85 L.Ed. 421 (1940). Here the transfer to taxpayer with a stepped-up basis, pursuant to § 334(b)(2), of the tires and tubes which had a substantial useful life remaining was inconsistent with the prior expensing of them, which indicated they had been or would be totally used up by Service. This inconsistency is enough to invoke the tax benefit rule.¹⁴

Second, even if a “recovery” is required to apply the tax benefit rule, there was such a recovery here. When the tires and tubes were expensed by Service they were, in contemplation of the tax laws, completely consumed. They had a zero basis and were considered a nonentity, but only in contemplation of their actual consumption by Service. At the time of the liquidation, an event of significance in the tax laws, they were transferred to taxpayer as a usable entity. This transfer belied the assumption that they would be wholly consumed by Service. Thus, in order for Service to be able to transfer them to taxpayer they must be deemed to have been recovered by Service at that time, as the Tax Court held. Taxpayer objects to this, claiming it is a “fictional” recovery. In a sense it is fictional but certainly no more so than the initial fiction that the tires and tubes would be completely consumed by Service in about one year in order to justify their being expensed. Taxpayer cannot equitably argue that Service should have the benefit of fictionally converting the tires and tubes into a nonentity (by expensing them) yet not have the burden of having them fictionally reconverted into tangible property (by applying the tax benefit rule). Spitalny v. United States, 430 F.2d 195, 198 (9th Cir. 1970).

Third, again assuming there need be an actual “recovery” in order to apply the tax benefit rule, there was a recovery here in another sense. Service received its own stock in exchange for the assets transferred to taxpayer. It is true that this stock had no value after the liquidation was completed, but it had considerable value at the time it was returned to Service. This is enough to satisfy any need for a “recovery” by Service in order to apply the tax benefit rule.¹⁵

United States v. Nash, 398 U.S. 1, 90 S.Ct. 1550, 26 L.Ed.2d 1 (1970), is relied upon by taxpayer but does not support its position. Nash involved a § 351 incorporation in which accounts receivable were transferred by the taxpayers to newly formed corporations. The taxpayers, before incorporation, had established a bad debt reserve and taken appropriate deductions. The Supreme Court held that the taxpayers did not “recover” the amount of the bad debt reserve upon incorporation. The reason, however, was that they had only transferred the net value of the receivables (face amount less bad debt reserve) to the new corporations and had received in exchange stock worth that net value. Id. at 4, 90 S.Ct. 1550. Thus, unlike the instant case, in Nash the taxpayers did not transfer an item (or any portion thereof) which had béen the subject of a prior deduction, but rather transferred only what was left after the deduction. Here, Service clearly transferred items which had been the subject of prior deductions. Furthermore, in Nash the bad debt reserve deduction reflected business reality since only the net value of the receivables could realistically be collected; here the expense deduction did not reflect business reality since the tires and tubes were not in fact consumed by Service. Nash simply does not stand for the proposition, for which it is cited by taxpayer, that the tax benefit rule only applies in the case of an actual physical, as opposed to “fictional,” recovery of a previously deducted amount.

The fundamental inequity of the result urged by taxpayer is that it would treat like cases differently. Sometimes an express statutory command necessitates this but that is not the case here. Indeed, § 337 was meant to work precisely the opposite result and do away with most “formalistic distinctions” between liquidations involving distributions in kind and sales of assets. We refuse to elevate form over substance by reviving technical differentiations put to rest in 1954 with the adoption of § 337.¹⁶

The judgment of the Tax Court is affirmed.

1 . The tax benefit rule provides that if an amount which was deducted from gross income in a prior year is recovered in a later year then the amount recovered is included in gross income in the later year. Alice Phelan Sullivan Corp. v. United States, 381 F.2d 399, 180 Ct.Cl. 659 (1967). See generally 1 J. Mertens, Law of Federal Income Taxation § 7.34. (1974 ed.). The rule is of judicial origin and has been codified in part in Internal Revenue Code § 111. Id.

2 . We also affirm the Tax Court on the issue of valuation raised by taxpayer for the reasons set forth in the opinion of the Tax Court.

3 . Internal Revenue Code §§ 332 and 336 provide that, as general rules, “no gain or loss shall be recognized” to taxpayer or Service, respectively, by virtue of this merger.

4 . The 1967 consolidated return showed a net operating loss, wholly attributable to taxpayer, which was tentatively carried back to reduce taxpayer’s tax liability for prior years.

5 . The Commissioner determined that the 1967 net operating loss was excessive and, consequently, that the tentative loss carryback was excessive.

6 . Service’s 1967 income was reported on the consolidated 1967 return, so increasing its income effectively reduced the taxpayer’s net operating loss. The Commissioner conceded that taxpayer was allowed to fully deduct in 1967 the amount allocated to the tires and tubes, which amount was contested, see note 2, supra, so the increase in Service’s income simply cancelled out taxpayer’s deduction and reduced the net operating loss by the amount attributable to the tires and tubes.

7 . One judge filed a concurring opinion and seven judges dissented. See O’Hare, Application of Tax Benefit Rule in New Case Threatens Certain Liquidations, 44 J.Tax. 200 (1976).

8 . Internal Revenue Code § 336:

Except as provided in section 453(d) (relating to disposition of installment obligations), no gain or loss shall be recognized to a corporation on the distribution of property in partial or complete liquidation.

9 . Internal Revenue Code § 337(a):

(a) General rule. — If, within the 12-month period beginning on the date on which a corporation adopts a plan of complete liquidation, all of the assets of the corporation are distributed in complete liquidation, less assets retained to meet claims, then no gain or loss shall be recognized to such corporation from the sale or exchange by it of property within such 12-month period.

10 . In particular, we noted § 337(b)’s unique denial of nonrecognition to gain or loss from sales in the ordinary course of business during the relevant twelve-month period.

11 . See B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders ¶] 11.62, p. 11-52 and H 11.65, p. 11-72 (3d ed. 1971) (hereinafter Bittker). This authority notes that applying the tax benefit rule to § 336 liquidations is the better result. It also suggests that courts may be hesitant to apply the rule in this context, citing, inter alia, Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (9th Cir. 1963), but we believe that we should not hesitate to avoid inequities in the tax laws which are not specifically mandated by Congress.

12 . The cases referred to are Commissioner v. Court Holding Co., 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981 (1945) and United States v. Cumberland Public Service Co., 338 U.S. 451, 70 S.Ct. 280, 94 L.Ed. 251 (1950). Court Holding “held that a liquidating corporation could not escape taxation on the gain realized from the sale of its sole asset if the corporation itself had arranged the sale prior to liquidation and distribution of the asset to the shareholders. This was so even though the sale was consummated after the distribution.” 417 U.S. at 679, 94 S.Ct. at 2520. Cumberland “reached exactly the opposite conclusion in a case where the shareholders, rather than the corporation, had negotiated the sale of the distributed assets and, prior to the corporation’s liquidation, had been in touch with the purchaser and had offered to acquire the property and sell it to the purchaser.” 417 U.S. at 680, 94 S.Ct. at 2520. See generally 417 U.S. at 678-83, 94 S.Ct. 2516.

13 . We reject the contrary holding in Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (9th Cir. 1963). See Rev.Rul. 77-67, 1977-1 C.B. 33; Rev.Rul. 74-396, 1974-2 C.B. 106.

14 . Moreover, by taking advantage of § 334(b)(2)’s stepped-up basis provision, taxpayer is employing a statutory device which recognizes that, in some circumstances, a purchase of stock is essentially a purchase of assets, thus giving the assets their pro rata share of the basis of the stock. This is wholly inconsistent with taxpayer’s assertion that Service had no “recovery”.

15 . This is consistent with the general rule expressed in Internal Revenue Code § 331(a) that amounts distributed on liquidation are to be treated as payment in exchange for the retired stock. While retirement of stock on liquidation is not completely analogous to a sale, the tax laws have treated this as a sale almost continuously since 1924. Bittker 1! 11.01, p. 11-2 & 3.

16 . See generally 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 (1972). Therein the author suggests that a statute may be necessary to reach the result announced herein, but we feel a statute is not necessary for the reasons set forth above. Rather, we agree with the author’s conclusion that refusal to apply the tax benefit rule to cases like this one “resurrects a discrepancy in tax treatment between pre-liquidation and post liquidation sales which section 337 was intended to eliminate.” Id. at 240. We also note that refusal to apply the tax benefit rule here would result in “another tax trap ... for the unwary” which would be “questionable as a matter of tax policy.” Id. at 245.