Higgins v. Smith (1940)

HIGGINS, COLLECTOR OF INTERNAL REVENUE, v. SMITH

No. 146

SUPREME COURT OF THE UNITED STATES

308 U.S. 473; 60 S. Ct. 355; 84 L. Ed.

406; 40-1 U.S. Tax Cas. (CCH) P9160; 23 A.F.T.R. (P-H) 800

December 5, 1939, Argued

January 8, 1940, Decided

PRIOR HISTORY: CERTIORARI TO THE CIRCUIT COURT OF APPEALS FOR THE SECOND

CIRCUIT.

CERTIORARI, post, p. 536, to review the reversal, on cross-appeals, of a

judgment in a suit brought by a taxpayer for refund of a sum paid as income

taxes.

DISPOSITION: 102 F.2d 456, reversed.

SYLLABUS: 1. Under @ 23 (e) of the Revenue Act of 1932, authorizing

in the computation of income tax deductions for losses sustained during the

taxable year, no deductible loss occurs upon a sale by the taxpayer to a

corporation wholly owned by him. P. 476.

2. The contention that this conclusion is inconsistent with prior

interpretations of the income tax laws and unfair to the taxpayer -- examined

and rejected. P. 478.

3. From the fact that @ 24 (a) (6) of the Revenue Act of 1934 provides

explicitly that losses determined by sales to corporations controlled by the

taxpayer are not deductible, it does not follow that the law formerly was

otherwise. P. 479.

4. Claims of error prejudicial to the taxpayer, arising out of the District

Court's rulings on evidence in this case, held without merit. P. 480.

COUNSEL: Assistant Attorney General Clark, with whom Solicitor

General Jackson and Messrs. Sewall Key, Arnold Raum, and Joseph M. Jones were on

the brief, for petitioner.

Mr. David Sher for respondent.

JUDGES: Hughes, McReynolds, Butler, Stone, Roberts, Black, Reed, Frankfurter,

Douglas

OPINIONBY: REED

OPINION: MR. JUSTICE REED delivered the opinion of the

Court.

Certiorari was allowed n1 from the judgment of the Circuit Court of Appeals

for the Second Circuit n2 on account of an asserted conflict between the

decision below and that of the Circuit Court of Appeals for the

Seventh Circuit in Commissioner v. Griffiths. n3

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n1 Post, p. 536.

n2 102 F.2d 456.

n3 103 F.2d 110, affirmed sub nom. Griffiths v. Commissioner, ante, p. 355.

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The issue considered here is whether a taxpayer under the circumstances of

this case is entitled to deduct a loss arising from the sale of securities to a

corporation wholly owned by the taxpayer. The statute involved is @ 23 (e) of

the Revenue Act of 1932. n4

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n4 47 Stat. 169, 179-80. "Sec. 23. Deductions from Gross Income.

"In computing net income there shall be allowed as deductions:

. . . .

"(e) Losses by Individuals. -- Subject to the limitations provided in

subsection (r) of this section, in the case of an individual, losses sustained

during the taxable year and not compensated for by insurance or otherwise --

"(1) if incurred in trade or business; or

"(2) if incurred in any transaction entered into for profit, though not

connected with the trade or business; . . ."

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The Innisfail Corporation was wholly owned by the taxpayer, Mr. Smith. It

was organized in 1926 under the laws of New Jersey. The officers and directors

of the corporation were subordinates of the taxpayer. Its transactions were

carried on under his direction and were restricted largely to operations in

buying securities from or selling them to the taxpayer. While its accounts were

kept completely separate from those of the taxpayer, there is no doubt that

Innisfail was his corporate self. As dealings by a corporation offered

opportunities for income and estate tax savings, Innisfail was created to gain

these advantages for its stockholder. One of its first acts was to take over an

option belonging to the taxpayer for the acquisition by exchange of a block of

Chrysler common stock. Through mutual transactions in buying and selling

securities, and receiving dividends, the balance of accounts between Innisfail

and the taxpayer resulted, on December 29, 1932, in an indebtedness from him to

Innisfail of nearly $ 70,000. On that date, as a partial payment on

this indebtedness, a number of shares of stock were sold to the corporation by

the taxpayer at market. The securities sold had cost the taxpayer

more than the price charged to the corporation, and in carrying out the

transaction the taxpayer had in mind the tax consequences to himself.

In computing his net taxable income for 1932, the taxpayer deducted as a loss

the difference between the cost of these securities and their sale price to his

wholly owned corporation. The Commissioner of Internal Revenue ruled against

the claim, whereupon respondent paid the tax and brought this suit for refund in

the United States District Court for the Southern District of New York. The

case was tried before a jury and the verdict was adverse to the taxpayer's

claim that the purported sales of these securities to Innisfail marked

the realization of loss on their purchase. On appeal the judgment was reversed

and the case remanded to the District Court for a new trial. It was the opinion

of the Court of Appeals that the facts as detailed above, as a matter of law,

established the transfer of the securities to Innisfail as an event determining

loss.

Under @ 23 (e) deductions are permitted for losses "sustained during the

taxable year." The loss is sustained when realized by a completed transaction

determining its amount. n5 In this case the jury was instructed to

find whether these sales by the taxpayer to Innisfail were actual transfers of

property "out of Mr. Smith and into something that existed separate and apart

from him" or whether they were to be regarded as simply "a transfer by Mr.

Smith's left hand, being his individual hand, into his right hand, being his

corporate hand, so that in truth and fact there was no transfer at all." The

jury agreed the latter situation existed. There was sufficient evidence

of the taxpayer's continued domination and control of the securities,

through stock ownership in the Innisfail Corporation, to support this verdict,

even though ownership in the securities had passed to the corporation in which

the taxpayer was the sole stockholder. Indeed this domination and control is so

obvious in a wholly owned corporation as to require a peremptory instruction

that no loss in the statutory sense could occur upon a sale by a taxpayer to

such an entity.

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n5 Burnet v. Huff, 288 U.S. 156, 161.

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It is clear an actual corporation existed. Numerous transactions were

carried on by it over a period of years. It paid taxes, state and national,

franchise and income. But the existence of an actual corporation is only one

incident necessary to complete an actual sale to it under the revenue act.

Title, we shall assume, passed to Innisfail but the taxpayer retained the

control. Through the corporate forms he might manipulate as he chose the

exercise of shareholder's rights in the various corporations, issuers of the

securities, and command the disposition of the securities themselves. There is

not enough of substance in such a sale finally to determine a loss.

The Government urges that the principle underlying Gregory v. Helvering n6

finds expression in the rule calling for a realistic approach to tax situations.

As so broad and unchallenged a principle furnishes only a general direction, it

is of little value in the solution of tax problems. If, on the other hand,

the Gregory case is viewed as a precedent for the disregard of a transfer of

assets without a business purpose but solely to reduce tax liability, it gives

support to the natural conclusion that transactions, which do not

vary control or change the flow of economic benefits, are to be dismissed from

consideration. There is no illusion about the payment of a tax exaction. Each

tax, according to a legislative plan, raises funds to carry on

government. The purpose here is to tax earnings and profits less expenses and

losses. If one or the other factor in any calculation is unreal, it distorts

the liability of the particular taxpayer to the detriment or advantage of the

entire tax-paying group. n7

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n6 293 U.S. 465.

n7 Cf. Stone v. White, 301 U.S. 532, 537.

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The taxpayer cites Burnet v. Commonwealth Improvement Company n8 as a

precedent for treating the taxpayer and his solely owned corporation as separate

entities. In that case the corporation sold stock to the sole stockholder, the

Estate of P. A. B. Widener. The transaction showed a book profit and the

corporation sought a ruling that a sale to its sole stockholder could not result

in a taxable profit. This Court concluded otherwise and held the

identity of corporation and taxpayer distinct for purposes of taxation. n9 In

the Commonwealth Improvement Company case, the taxpayer, for reasons

satisfactory to itself voluntarily had chosen to employ the

corporation in its operations. A taxpayer is free to adopt such organization

for his affairs as he may choose and having elected to do some business as a

corporation, he must accept the tax disadvantages. n10

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n8 287 U.S. 415.

n9 See also Klein v. Board of Supervisors, 282 U.S. 19; Dalton v. Bowers, 287

U.S. 404; Burnet v. Clark, 287 U.S. 410.

n10 Cf. Edwards v. Chile Copper Co., 270 U.S. 452, 456.

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On the other hand, the Government may not be required to acquiesce in the

taxpayer's election of that form for doing business which is most advantageous

to him. The Government may look at actualities and upon determination that the

form employed for doing business or carrying out the challenged tax event is

unreal or a sham may sustain or disregard the effect of the fiction

as best serves the purposes of the tax statute. To hold otherwise would permit

the schemes of taxpayers to supersede legislation in the determination of the

time and manner of taxation. It is command of income and its

benefits which marks the real owner of property. n11

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n11 Lucas v. Earl, 281 U.S. 111; Corliss v. Bowers, 281 U.S. 376; Griffiths

v. Commissioner, ante, p. 355.

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Such a conclusion, urges the respondent, is inconsistent with the prior

interpretations of the income tax laws and consequently unfair to him. He

points to the decisions of four courts of appeals which have held losses

determined by sales to controlled corporations allowable n12 and further calls

attention to the fact that the Board of Tax Appeals has consistently reached the

same conclusion. n13 But this judicial and administrative construction has no

significance for the respondent. The Bureau of Internal Revenue has insistently

urged since February 18, 1930, the date of the Board of Tax Appeals'

decision in Jones v. Helvering, n14 that a transfer from a taxpayer to a

controlled corporation was ineffective to close a transaction for the

determination of loss. Every case cited by respondent in the courts of appeals

and before the Board of Tax Appeals found the Government supporting that

contention. The Board's ruling in the Jones case was standing

unreversed at the time of the transaction here involved, December 29, 1932. It

was only after the transactions here involved and after the reversal of the

Board in the Jones case on April 23, 1934, or this Court's refusal of certiorari

on October 8, 1934, that the Board of Tax Appeals and the courts of appeals,

over Government protests, ruled in line with the opinion of the Court of Appeals

of the District of Columbia in the Jones case. If the Bureau's stand in the

Jones case represented a change in administrative practice, there can be no

doubt that the change operated validly at least from 1930 on. n15 After the

Jones defeat the Government sought relief in Congress and after the judgment in

Commissioner v. Griffiths, supra, certiorari here on a conflict in principle

between circuits. Certainly there was no acquiescence by the

Government which would justify the taxpayer in relying upon prior

interpretations of the law. n16

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n12 Jones v. Helvering, 63 App. D. C. 204; 71 F.2d 214 (April 23, 1934,

reversing 18 B. T. A. 1225, decided February 18, 1930), cert. denied October 8,

1934, 293 U.S. 583; Commissioner v. Eldridge, 79 F.2d 629 (November 4, 1935,

affirming 30 B. T. A. 1322, decided July 31, 1934); Commissioner v. McCreery, 83

F.2d 817 (May 13, 1936, affirming B. T. A. memorandum opinion of June 19, 1935);

Foster v. Commissioner, 96 F.2d 130 (April 18, 1938, affirming B. T. A.

memorandum opinion of December 23, 1935); Helvering v. Johnson, 104 F.2d 140

(June 1, 1939, affirming 37 B. T. A. 155, decided January 21, 1938), affirmed by

an equally divided Court, post, p. 523.

n13 David Stewart v. Commissioner, 17 B. T. A. 604; Corrado & Galiardi, Inc.

v. Commissioner, 22 B. T. A. 847; Edward Securities Corporation v. Commissioner,

30 B. T. A. 918; Ralph Hochstetter v. Commissioner, 34 B. T. A. 791; John Thomas

Smith v. Commissioner, supra, 40 B. T. A. 387.

n14 18 B. T. A. 1225, a rehearing affirmed May 26, 1932, unpublished.

n15 Helvering v. Wilshire Oil Co., ante, p. 90.

n16 Cf. Estate of Sanford v. Commissioner, ante, p. 39.

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Respondent makes the further point that the passage of @ 24(a)(6)

of the Revenue Act of 1934 n17 which explicitly forbids any deduction for losses

determined by sales to corporations controlled by the taxpayer is convincing

proof that the law was formerly otherwise. This does not follow. At

most it is evidence that a later Congress construed the 1932 Act to recognize

separable taxable identities between the taxpayer and his wholly owned

corporation. As the new provision goes much farther than the former decisions

in disregarding transfers between members of the family it may well have been

passed to extend as well as clarify the existing rule. The suggestion is not

sufficiently persuasive to give vitality to a futile transfer.

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n17 48 Stat. 680, 691. "Sec. 24. Items not Deductible.

"(a) General Rule. -- In computing net income no deduction shall in any case

be allowed in respect of --

. . . .

"(6) Loss from sales or exchanges of property, directly or indirectly, (A)

between members of a family, or (B) except in the case of distributions in

liquidation, between an individual and a corporation in which such individual

owns, directly or indirectly, more than 50 per centum in value of the

outstanding stock. For the purpose of this paragraph -- (C) an individual shall

be considered as owning the stock owned, directly or indirectly, by his family;

and (D) the family of an individual shall include only his brothers and sisters

(whether by the whole or half blood), spouse, ancestors, and lineal

descendants."

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The taxpayer has preserved two objections to the district judge's rulings on

the evidence. He claims that evidence as to transactions between the taxpayer

and the corporation which took place prior to the sale here involved was remote

and highly prejudicial. We think it apparent that this evidence was entirely

relevant to the present issue; the history of the taxpayer's relations with the

corporation shed considerable light on the actual effect of the sale in

question. The second contention is that the district judge charged the jury to

give less effect to the book entries of Smith and the corporation than they

were entitled to under the applicable book entry statute. n18 The alleged

departure from the statute has but dubious support in the record, resting on a

single statement of the judge lifted from its context as part of an extended

colloquy with counsel. In the circumstances there is no merit in the claim of

prejudice to the taxpayer.

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n18 49 Stat. 1561, 28 U. S. C. @ 695.

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The judgment of the Circuit Court of Appeals is reversed and that

of the District Court affirmed.

Reversed.

DISSENTBY: ROBERTS

DISSENT: MR. JUSTICE ROBERTS, dissenting.

I think the judgment should be affirmed. To reverse it is to disregard a

rule respecting the separate entity of corporations having basis in logic and

practicality and which has long been observed in the administration

of the revenue acts.

Since the inception of the system of federal income taxation, capital gains

have been taxed and certain capital losses have been allowed as credits against

such gains. In order that this system might be practical it has been necessary

to select some event as the criterion of realization of gain or loss. The

revenue laws have selected the time of the closing of a capital transaction as

the occasion for reckoning gain or loss on a capital asset. A typical method of

closure is a sale of the asset.

As the sale is voluntarily made by the taxpayer, his determination when he

shall sell affects his capital gain or loss. He, therefore, in a sense,

controls the question whether, in a given taxable year, he must pay tax on a

realized gain or may claim credit for a realized loss. Of course such a sale

must be bona fide and title must pass absolutely. In the present

instance the sale and transfer were such, and, as the Circuit Court of Appeals

held, there was not a scintilla of evidence to the contrary for the jury's

consideration. A taxpayer who pretends he has made a sale when in fact he has a

secret agreement which leaves him still, for all practical purposes, the

owner of the thing sold, is but committing a fraud upon the revenue.

If the sale is bona fide, if title in fact passes irrevocably to another,

that other takes as his basis, in reckoning his gain and loss, the price he paid

for the asset; and upon his future disposition of it there will be a new

reckoning of gain or loss with respect to such disposition. Here, if Innisfail

either sold to the respondent or to a third party it would have to reckon gain

or loss on the sale. If it distributed the asset in liquidation the respondent

would be subject to a tax liability on the receipt of his dividend. The sole

question, then, is whether, as matter of law, a bona fide and absolute sale to a

wholly owned corporation can constitute a completed transaction,

determining a loss.

The problem as to how a sale to a corporation wholly owned or

wholly controlled by an individual taxpayer is to be treated is not a new one.

The existence of such corporations and the dealings between them and their

stockholder or stockholders have long been understood. Congress was not

ignorant of the problem. n1 At the outset Congress might well have adopted the

policy that a sale by the stockholder to the corporation, or vice versa, should

be disregarded, and the stockholder treated as in effect the owner of the

capital asset until its sale to a stranger. On the other hand, it would be a

practical policy to recognize the separate entity of the corporation, to treat a

transfer at current value for adequate consideration occurring between it and

its sole stockholder as closing a transaction for the purpose of reckoning

either gain or loss, and then to tax the vendee upon his or its gain or loss

upon a subsequent transfer by comparison of the basis on which the asset was

acquired and the amount realized on final disposition by the vendee. In fact,

the latter course was adopted and was consistently followed until 1934 when

Congress dealt with the subject.

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n1 The Revenue Act of 1932, c. 209, 47 Stat. 169, 196, @ 112 (b) (5),

provided: "No gain or loss shall be recognized if property is transferred to a

corporation by one or more persons solely in exchange for stock or securities in

such corporation, and immediately after the exchange such person or persons are

in control of the corporation; . . ."

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This court, speaking by Mr. Justice Holmes, said, in Klein v. Board of

Supervisors, 282 U.S. 19, 24: ". . . But it leads nowhere to call a corporation

a fiction. If it is a fiction it is a fiction created by law with intent that

it should be acted on as if true. The corporation is a person and

its ownership is a nonconductor that makes it impossible to attribute an

interest in its property to its members."

In this view assets received on the liquidation of a one-man corporation

constitute taxable income to the sole stockholder. n2 Likewise, losses sustained

by a corporation wholly owned by one individual may not be reported and claimed

in the individual tax return of the latter. n3 And the sole stockholder and his

controlled corporation may not tack successive periods of ownership to make up

the two years required for an asset to become, within the meaning of the

statute, a capital asset. n4

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n2 France Co. v. Commissioner, 88 F.2d 917; Coxe v. Handy, 24 F.Supp. 178;

John K. Greenwood, 1 B. T. A. 291.

n3 Dalton v. Bowers, 287 U.S. 404; Menihan v. Commissioner, 79 F.2d 304.

n4 Webber v. Knox, 97 F.2d 921.

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This court has found that a taxable gain was realized in a case where a

wholly owned corporation sold securities to its sole stockholder. n5 Every

element appearing in that case is paralleled here, as a comparison of the

facts stated in the opinions in the two cases will demonstrate. This court

said, in the earlier case, referring to the corporation: "The fact that it had

only one stockholder seems of no legal significance," and held the corporation a

separate taxable entity. It is now said, however, that there is no inequity in

not applying the same rule to losses as to gains because the taxpayer who

exercises the option to conduct a portion of his business through the

instrumentality of a wholly owned corporation does so in the full

knowledge that, if he does, gains shown on sales by him to the corporation will

be taxed whereas losses on such sales will not be allowed as deductions. As

hereafter will be shown, this is now true in virtue of the amendment

embodied in the Revenue Act of 1934 but it was not true as the law stood before

the adoption of that amendment.

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n5 Burnet v. Commonwealth Improvement Co., 287 U.S. 415.

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In 1921 the Treasury was first called upon to deal with a loss deduction

arising out of a sale to a wholly owned corporation. In that year it published

Law Opinion 1062. n6 It was held that if the sale was bona fide and passed title

absolutely to the controlled corporation, even though the sale was made with the

intent of reducing the tax liability of the vendor it fell within the provisions

of the revenue act concerning the reckoning of gain or loss upon a closed

transaction. So far as I am informed, the Treasury followed this rule in

administering the various revenue acts for years after it was issued. The first

evidence of a change in its position was the refusal of the Commissioner of

Internal Revenue to recognize losses resulting to taxpayers from a bona fide

sale of bonds owned by them to a wholly owned corporation at the current market

price. n7 The Board of Tax Appeals sustained the Commissioner, but the Court of

Appeals of the District of Columbia reversed the Board in Jones v.

Helvering, 71 F.2d 214. The decision was rendered April 23, 1934. The

Commissioner sought certiorari which was denied October 8, 1934. n8 The same

result has been reached by three other Circuit Courts of Appeal. n9 The Board of

Tax Appeals followed these decisions. n10 In the meantime the Circuit

Courts of Appeal had decided numerous cases which are, in principle,

indistinguishable. n11

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n6 4 C. B. 168, cited with approval inG. C. M. 3008 VII-1 C. B. 235.

n7 Jones v. Commissioner, 18 B. T. A. 1225 (1930).

n8 293 U.S. 583.

n9 Commissioner v. Eldridge, 79 F.2d 629 (C. C. A. 9); Commissioner v.

McCreery, 83 F.2d 817 (C. C. A. 9); Helvering v. Johnson, 104 F.2d 140 (C. C. A.

8); Foster v. Commissioner, 96 F.2d 130 (C. C. A. 2); Smith v. Higgins (the

instant case), 102 F.2d 456 (C. C. A. 2).

n10 David Stewart, 17 B. T. A. 604; Corrado & Galiardi, Inc., 22 B. T. A.

847; Ralph Hochstetter, 34 B. T. A. 791; John Thomas Smith, 40 B. T. A. 387,

involving prior years of the taxpayer in this case.

n11 Iowa Bridge Co. v. Commissioner, 39 F.2d 777; Taplin v. Commissioner, 41

F.2d 454; Commissioner v. Van Vorst, 59 F.2d 677; Marston v. Commissioner, 75

F.2d 936; St. Louis Union Trust Co. v. United States, 82 F.2d 61; Sawtell v.

Commissioner, 82 F.2d 221; Commissioner v. Edward Securities Co., 83 F.2d 1007,

affirming 30 B. T. A. 918.

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This court having denied certiorari in Jones v. Helvering, supra, decided

Gregory v. Helvering, 293 U.S. 465, in the following January. It cited the

Jones case with approval, at p. 469, saying: ". . . The legal right of a

taxpayer to decrease the amount of what otherwise would be his taxes, or

altogether avoid them, by means which the law permits, cannot be doubted."

So well settled had the judicial interpretation become that the Treasury

determined to recommend that Congress amend the statute. n12 The result was the

adoption of @ 24 (a) (6) of the Revenue Act of 1934. n13 The committee reports

disclose that Congress thought it necessary to change the statute in order to

render nondeductible a loss claimed on a sale to a wholly owned or a

controlled corporation. n14 Subsequent hearings before the Joint Commission

on Tax Evasion and Avoidance, 1937, p. 207, indicate the same

understanding on the part of the Bureau of Internal Revenue and of Congress that

the rule of law in effect prior to the adoption of the amendment in

1934 was changed by that legislation. The amendment lists among items not

deductible the following:

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n12 In the Hearings before the Joint Committee on Tax Evasion and Avoidance,

1937, p. 206, it appears that the Solicitor General considered the law so well

settled that he refused to apply for certiorari in the Eldridge case, supra,

note 9, although the Treasury recommended such action.

n13 48 Stat. 680, 691.

n14 See the report of the Committee on Ways and Means of the House of

Representatives, H. R. 704, 73d Cong., Second Sess., p. 23; Senate Report 588,

73d Cong., Second Sess., p. 27; see also the hearings before the Committee on

Ways and Means, Revenue Revision, 1934, p. 134.