NASH v. UNITED STATES
Legal provision: Internal Revenue Code
Argument of Harold I. Apolinsky
Chief Justice Warren E. Burger: Next case on for argument is number 678, Nash against the United States.
Mr. Apolinsky' you may proceed whenever you’re ready.
Mr. Harold I. Apolinsky: Mr. Chief Justice and may it please the Court.
This is an income tax case on the writ of certiorari to the United States Court of Appeals for the Fifth Circuit.
The question is whether the balance in a reserve for bad debts maintained by a partnership and stipulated by the parties to be reasonable must be taken into ordinary income or not by the partnership when it incorporates its business under Section 351 of the Internal Review Code.
Section 351 providing that no gain or loss will be recognized if property is transferred to a controlled corporation and it’s agreed by the parties that the transfers' the incorporations here are within the purview of Section 351.
Chief Justice Warren E. Burger: What would have happened to this reserve if they have liquidated Mr. Apolinsky?
Mr. Harold I. Apolinsky: If the partnership had liquidated --
Chief Justice Warren E. Burger: They just liquidated it would've -- would it have gone into ordinary income then?
Mr. Harold I. Apolinsky: No, Your Honor, under the partnership concept, liquidating to the various partners, each would have taken his pro rata part of the receivable with the reserve and it would not have come into the income of the partners.
Chief Justice Warren E. Burger: It wouldn't have entered the transaction at all?
Mr. Harold I. Apolinsky: No sir.
Because you have come straight through.
Justice Potter Stewart: He should have taken his pro rata part of the receivables plus -- and his pro rata part of the reserve, is that right?
Mr. Harold I. Apolinsky: Yes, Mr. Justice Stewart --
Justice Potter Stewart: The partnership probably has to report as an entity, it isn’t a taxable entity basically?
Mr. Harold I. Apolinsky: That’s right.
Justice Potter Stewart: It’s a group of individuals?
Mr. Harold I. Apolinsky: That's right and in this situation, this partnership operated 10 finance businesses, two in South Carolina and eight in Alabama.
It made loans to the public and it used the accrual method of accounting under which it would take into its ordinary income the profit on a loan, the receivable in the year in which the loan was made and the receivable established.
It accounted for its bad debts by the use of the reserve method for the bad debts allowed under Section 166 of the Code.
Actually, a taxpayer can use either of two methods.
It can use the direct charge-off method which allows you to charge against income in the year that the account goes bad or a taxpayer can anticipate its losses as far as specific accounts are concerned and establish a reserve for bad debts and based on its experience, estimate the amount of the accounts receivable which will go bad and charge that amount against income when it establishes its reserve.
The reserve is reviewed annually and any additions to the reserve are likewise charged against income as a deduction and they're limited of course to the reasonableness of the reserve which in our situation is stipulated.
On May 31, 1960, the partnership had about approximately $487,000.00 worth of receivables in these eight Alabama offices and approximately a $73,000.00 balance in its reserve for bad debts applicable to those eight offices.
It then on June 1 transferred to eight separate corporations for it attained a benefit under the Alabama loan licensing statutes by have eight separate corporate offices that could lend money and it transferred to those eight offices the receivables applicable to the eight corporations.
The furniture and fixtures applicable to the eight corporations, cash applicable to the eight corporations and liabilities taking back stock and security solely for the net value transferred to the partnership to the corporations.
It continued the same businesses in the eight corporations and what it did, the corporations then set up the reserve, they had an opening balance which they reflected in their reserve for bad debts in total and we’re dealing here in both briefs with the total concept.
The total amount of the reserves reflected in the opening balance sheets of these eight corporations was $73,000.00.
In 1962, the Commission of Internal Revenue issued his Revenue Ruling 62-128 where he first expressed the position that the reserve for which being maintained by a partnership would be taken back into the ordinary income of the partnership when it transfers its assets even though such transfer being under the tax free rules generally of Section 351 and thereafter, the Commissioner's agent examined the returns of the partnership which made a determination that the $73,000.00 of reserve should be restored to the ordinary income of the partnership in its year which ended in 1961.
This increased the distributive share of income to the partners and therefore the partner’s income increased in 1961.
They paid their tax, filed a claim for refund and filed suit in District Court, the District Court upholding the taxpayer's position that the reserve would not be restored to income relying on the Ninth Circuit Court of Appeals case of the Estate of Heinz Schmidt.
The Government’s appeal to the Fifth Circuit where the Fifth Circuit said they disagreed with the Ninth Circuit and agreed with the Tax Court and sustained the Commissioner's position and hence this writ of certiorari.
We maintain that the clear legislative history of Section 351 precludes this end rule, this creation of income to the partnership when it incorporates its business under that Section.
It came into the law.
Section 351 came into the law in 1921 at the same time Congress first enacted the reorganization provisions and also enacted the tax free exchanges of real estate provisions.
And the Senate's Finance Committee in its report in 1921 said that they had been -- they recounted that the prior law, under the prior law before 1921, this would have been a taxable event, a reorganization or the organization of a corporation as we have here would be in a taxable event before 1921 and they said there had been no provision which had more seriously interfered with necessary business readjustments than these prior laws and therefore they put in these tax free exchange provisions.
They said they specifically sought to eliminate technical constructions which are economically unsound and interfered with necessary business readjustments.
In 1924, Congress considered the carryover basis sections of the code which are the corollary to tax-free exchanges, the corporation taking a carryover basis and they had an opportunity to express their views again, the House Ways and Means Committee as to the purpose of the predecessor of Section 351 of the Code where they said that this Section 351 and the reorganization sections were not intended to be exemptions from taxation.
That they were recognitions that these changes were merely changes in form and not in substance and would not be given to recognition of income, that any recognition of income would be postponed until there was an actual sale or a taxable exchange.
Justice Potter Stewart: What would be the, under your theory your client's partners should not have added back into their income the amount there before set up as a reserve for bad debt and what would be the result vis-à-vis the newly created corporation?
Mr. Harold I. Apolinsky: We would say the result is what did happen in our situation.
The corporation set up a reserve for bad debts.
It had a balance --
Justice Potter Stewart: Which was identical?
Mr. Harold I. Apolinsky: Identical.
Justice Potter Stewart: In amount, I mean.
Mr. Harold I. Apolinsky: It's open.
It's had $73,000.00 in it.
Now, that amount was not charged against corporate income for the first year as a reduction of income which is the Government’s position.
The Government says take it into the income of the partnership and give the corporation a new deduction in its first year for $73,000.00.
Justice Potter Stewart: And you say, don’t take it into the income of the partnership and don't give the corporation a deduction on its first year?
Mr. Harold I. Apolinsky: Yes, Mr. Justice.
Justice Potter Stewart: And I suppose also the basis of the stock received by the partners in return for the transfer of the partnership assets would be reduced, it would be a net, it would be the amount of assets represented by the accounts receivable less the reserve would it not?
Mr. Harold I. Apolinsky: That’s right.
Justice Potter Stewart: It will be a net figure.
Mr. Harold I. Apolinsky: The net figure.
Justice Potter Stewart: And that -- so the basis in the hands -- of the stock in the hands of the partners would be lowered, therefore on any subsequent sale or taxable transfer, their capital gain would be higher, is that right?
Mr. Harold I. Apolinsky: That's right.
Justice Potter Stewart: Is that what would follow?
Mr. Harold I. Apolinsky: Yes.
Justice Potter Stewart: In your theory.
Mr. Harold I. Apolinsky: Yes, Mr. Justice Stewart.
Justice Byron R. White: And the corporation would never get a deduction.
Mr. Harold I. Apolinsky: For that $73,000.00.
Justice Byron R. White: For that $73,000.00 in the first year or any other time?
Mr. Harold I. Apolinsky: Or any other year.
Justice Potter Stewart: Because on this year, they haven’t paid anything for that $73,000.00 worth of accounts receivable.
Mr. Harold I. Apolinsky: That's right, that it was just a mere change in form.
The Government in their brief cast this poll of an expected double deduction that the Code is to be construed to prevent double deductions.
We took no double deduction.
We set it up on the corporate books without deducting against corporate income.
Our taxpayer considers his stock to be worth net.
The section’s both the reserve for bad debts came into the Section coincidentally in 1921.
The same year that the predecessor of our tax-free organization Section 351 came in, we have found no case, nor has the Government cited any case since 1921 where any corporation has so a second deduction or any taxpayer has tried to take a second deduction.
Justice Byron R. White: I take it the Government would take the same position as the corporation that paid the partner's cash for the accounts receivable in their face amount less the amount of the reserve.
Mr. Harold I. Apolinsky: If they pay the partner's cash in the face amount?
Justice Byron R. White: If they just bought -- if they bought the accounts receivable, paid cash in the face amount less the $73,000.00.
Mr. Harold I. Apolinsky: They would take -- well, that’s a difficult question to immediately answer for this reason, they would say that if you had a non -- if you had a taxable sale of the receivables at net, face amount less the reserve that under -- that there is no income because they seek to offset a return of the reserve to income by a loss on the receivables.
Now if you had, they say however in our situation, this is a tax-free exchange which precludes recognition of gain or loss and therefore there is no loss that can be recognized to the transferring partners to offset the return of the reserve to income so that their position in a taxable exchange would be that there would be no income but if we had a transfer of the receivables in exchange for cash in a nontaxable environment, then their answer would probably be the same.
Justice Byron R. White: Do you think it’s different then if it's a corporation and the partners had in valuing the assets to be transferred and specifically allocated a value to the accounts receivable, the face amount less the amount of the reserve?
Mr. Harold I. Apolinsky: Their result would not be any different.
Justice Byron R. White: Even though the corporation didn't purport to pay you any more than the net amount?
Mr. Harold I. Apolinsky: Had the corporation instead of turning up a reserve simply established on its books receivables at the net amount of $414,000.00, the net amount, their answer would have been the same.
Justice Byron R. White: They still think you have realized income?
Mr. Harold I. Apolinsky: They still think we realized income.
Now, they cite which I think is a good case and I wish I had cited it, the Skelly Oil opinion where they say that the court will not permit any double deduction and I believe that with that decision, it would be inconceivable that if a corporation tried to come into court later on, or a taxpayer tried to come into court to get a second deduction that that would ever be allowed.
Chief Justice Warren E. Burger: I might test your position from another angle.
Suppose, this is a large hypothetical because it wouldn't happen, but suppose after the corporate reorganization was completed, the corporation was taken over, someone came along and offered to buy all of the receivables of the new corporation which had just been transferred to it for 100 cents on the dollar, then what would happen to the reserve?
Mr. Harold I. Apolinsky: This is what would happen, Mr. Justice Burger.
The corporation would then have recovered the full amount of its receivables.
Chief Justice Warren E. Burger: Would it be charged all of the bad debt loss, the reserve would go into income then wouldn’t it?
Mr. Harold I. Apolinsky: Would go into income by the corporation.
Chief Justice Warren E. Burger: And this hasn't happened and never will happen unless some fairy godmother comes along and buys these at 100 cents on the dollar, isn’t that right?
Mr. Harold I. Apolinsky: That's right, and if that happened quite soon after the incorporation, I think the Commissioner would come in and say the reserve wasn't reasonable in amount and would probably seek to have the partnership pay some income tax on it because if the reserve is not reasonable, he’s got other rules that they would apply and we would not argue with it but in our situation, it stipulated that the reserve is reasonable.
Justice Byron R. White: If somebody talked to the -- the accounts receivable would have at their face amount and not for that amount, you would realize income?
Mr. Harold I. Apolinsky: We would realize income.
We would say --
Justice Byron R. White: Not that you would have to do --
Mr. Harold I. Apolinsky: That's right, we would say that the tax benefit rule which the Government espouses in their brief correctly but doesn’t apply, would apply.
The tax benefit rule which they say is the basis for the Revenue Ruling 62-128 says that if you take a deduction in a prior year, it is of tax benefit in the prior year and you subsequently recovered the deduction, then you have to take into income the amount of the recovery in the year of the recovery.
Justice Byron R. White: That reserve really just makes you a tax basis taxpayer with the amount of that reserve.
It will pay off if you collect some of those.
Mr. Harold I. Apolinsky: If you collect those accounts in, then you do have -- in other words, you have a recovery of the reserve.
We say in this nontaxable situation was a mere change in form that there is -- and this was the philosophy I think of the Ninth Circuit.
The Fifth Circuit ignored Section -- well, they mentioned it but they did not give a lot of weight to Section 351.
The Ninth Circuit didn't either but they grounded their opinion on the fact that there was no recovery, that the philosophy of the government in using the tax benefit rule to take -- to recover the bad debt in some future point should be based on the fact that there is a recovery at some later year of the amount of the reserve and that when you get back stock certificates representing the net value of the assets transferred, the accounts receivable less the value, that there was no recovery.
Justice Byron R. White: But at least that there is some recovery in this reserve account, the result of your position of being a corporation that would pay a corporate --
Mr. Harold I. Apolinsky: That's right.
Justice Byron R. White: -- tax rate rather than you would have called it paying individual.
Mr. Harold I. Apolinsky: Well, you would pay a -- you would not have an immediate recognition at the beginning where you could have a higher rate or you could have a lower rate I imagine.
At that time -- either way at that time, the corporation takes it back into its income depending on the two rate structures.
Justice Byron R. White: What’s the result of the government's position?
Assume the government prevails and you have to take -- the partners have to take the $73,000.00 into income, then what -- I suppose that $73,000.00 worth of accounts receivable could be recovered by the corporation for nothing.
Mr. Harold I. Apolinsky: That's right, you see what would happen, we would take it --
Justice Byron R. White: Does the Government conceive that?
Mr. Harold I. Apolinsky: I don't -- we really not put it to --
Justice Byron R. White: You mean the tax would then have been paid on those accounts receivable?
Mr. Harold I. Apolinsky: If we had to take -- if the partners took the $73,000.00 worth of receivables into income, then they would -- they say in their brief that the corporation would then be entitled to set up a $73,000.00 reserve for bad debts in its first year.
Now if the corporation chose to do that and take a deduction of $73,000.00 in its first year and later recovered the $73,000.00 --
Justice Byron R. White: Tax has already been paid on it.
Mr. Harold I. Apolinsky: That's right, it’s been paid but you could have -- if you had a second deduction under their theory you could have a second tax to pay on it.
We say that would just really distort the income of the new corporation giving it a whopping big deduction in the first year when it has no earnings necessarily, it's not related to any business activity and creates an income item to the partnership.
I see that I'm going to reserve the balance of my time for rebuttal, Your Honor.
Chief Justice Warren E. Burger: Very well, Mr. Apolinsky.
Argument of Matthew J. Zinn
Mr. Matthew J. Zinn: Mr. Chief Justice and may it --
Chief Justice Warren E. Burger: Before you get underway, would you clarify perhaps for all of us but at least for me, what has changed here in your judgment by this transfer except the form and structure of doing business?
Mr. Matthew J. Zinn: That is precisely all that has changed Mr. Chief Justice, just the form in which the business is carried on.
Chief Justice Warren E. Burger: There's no change in substance?
Mr. Matthew J. Zinn: That's correct although as we pointed out in our brief, Section 351 transfers can apply where an entire business becomes a corporation or where a single asset on account receivable or any other single asset is transferred from an individual or partnership to a controlled corporation.
Justice Hugo L. Black: What goodness has this partnership engaged in?
Mr. Matthew J. Zinn: It was engaged in the business of financing, Mr. Justice Black.
Justice Hugo L. Black: Lending money?
Mr. Matthew J. Zinn: I believe so.
Justice Hugo L. Black: Is it a challenge to the question as to the amount they have tried to set aside for bad debt?
Mr. Matthew J. Zinn: No, Mr. Justice Black.
If I understand your question, the reserve that was on the books of the corporation at that time of the transfer, on the books of the partnership, excuse me, at that time of the transfer, was reasonable if the partnership continued in business.
But the fact is that the partnership didn't continue in the business.
The partnership was terminated and all of its assets including its accounts receivable which were transferred to the corporation.
Justice Hugo L. Black: But why did that change the situation with reference to the reasonableness of the amount?
Mr. Matthew J. Zinn: Well, we think that when a partnership terminates or when an entity terminates, the tax benefit principle requires that a deduction be restored to income because subsequent events have demonstrated that that entity is not entitled to the deduction.
Justice Hugo L. Black: Does the record show that?
At subsequently event?
Mr. Matthew J. Zinn: Well, if the partnership and corporation are considered to be separate entities, I don’t think there can be much question that the partnership’s need for the reserve ended.
The Ninth Circuit in the Schmidt case upon which petitioners rely determined that the need --
Justice Hugo L. Black: They had changed their --
Mr. Matthew J. Zinn: The form of the business as the Chief Justice asked.
Justice Hugo L. Black: -- in form from a partnership to a corporation?
Mr. Matthew J. Zinn: That’s correct and Mr. Apolinsky this morning and in his brief has relied heavily on the legislative history of Section 351 which provides for the nonrecognition of gain or loss.
But he did not read the language of the statute to this Court and I would like to do that.
It says that 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.
And immediately after the exchange such person is in control of the corporation.
No gain or loss shall be recognized.
Gain or loss is a statutory term of art.
It can arise only when property is transferred.
The reserve for bad debts is not property.
It is merely a bookkeeping entry on the books of the partnership.
It cannot be transferred and nothing in Section 351 bars the application of a tax benefit principle in this case.
Justice Byron R. White: No, but it's reported to be transferring reserves.
Mr. Matthew J. Zinn: They are transferring only the receivables.
Justice Byron R. White: All that it's saying is that they're transferring the accounts receivable at face amount less the amount of the reserve.
They're transferring only the net amount of the -- because everybody stipulates that these transfers are only worth so much.
Mr. Matthew J. Zinn: Yes, but Section 351 only prohibits the recognition of gain or loss and restoring the reserve income under the tax benefit principle is not a recognition of gain or loss.
Justice Byron R. White: That may be so.
Mr. Matthew J. Zinn: Well, there’s no -- I think the point is Mr. Justice White that there is no provision in the statute that precludes the application of the tax benefit principle in this case.
That principle is well established.
The need for the reserve here we think has terminated because the partnership has terminated.
Justice Byron R. White: Well, just because there’s nothing in the statute doesn't -- that suggests the application of the tax benefit principle doesn’t agree.
That principle is applicable here.
Mr. Matthew J. Zinn: I would respectfully disagree, Mr. Justice White.
Justice Byron R. White: What possible then it has -- has come out of this transfer to the partners?
Mr. Matthew J. Zinn: They have received -- the partnership has received the benefit of a deduction to which they are no longer entitled.
Justice Byron R. White: They received the benefit of it because the Government agreed that the accounts receivable of the books weren't all collected?
Now, you are saying that you must pay taxes though all of these accounts receivable were --
Mr. Matthew J. Zinn: That is correct.
That is correct.
Justice Byron R. White: And that we are no longer entitled to view this bundle of accounts receivable worth less than the face?
Mr. Matthew J. Zinn: That's right.
I think the accounts receivable are separate from the reserve.
Let me point out Mr. Justice White that when a corporation --
Justice Byron R. White: What's so attractive about that?
Let's say somebody must treat his collectible, his accounts receivable and we all agreed worth the collectible, and he must pay taxes on it?
Mr. Matthew J. Zinn: I don't know if there's anything attractive about it.
As we tried to point out in our brief, we view the problem here as initially one of avoiding a double deduction.
Justice Byron R. White: What possible double deduction can anybody ever get?
Mr. Matthew J. Zinn: Well, the concern we have initially, Mr. Justice White is that a deduction will be granted to the partnership as it was here and then that it will pay second deduction will be granted to the transferee corporation.
Justice Byron R. White: (Inaudible)
Mr. Matthew J. Zinn: I think they would try not to Mr. Justice White but I don’t think we can rule out that possibility.
Judge Duniway in his opinion in the Schmidt case specifically left open the question as to --
Justice Byron R. White: Because the corporation might have taken in, in fact that’s when it must make sure to charge somebody else more than it should.
Mr. Matthew J. Zinn: No, I don’t think that's the case.
It seems to me that we want to ensure against the double deduction.
The Code doesn’t specifically tell us which way to do that.
Justice Byron R. White: It was unsure, I guess?
Mr. Matthew J. Zinn: Right.
Justice Byron R. White: By taxing someone on some income that they haven't received yet and are --
Mr. Matthew J. Zinn: Well, we say they have received it Mr. Justice White.
Justice Byron R. White: That's only my picture of the full basis accounting anywhere?
Mr. Matthew J. Zinn: But the deduction for a reserve for bad debts is a fiction too.
We are allowing a deduction --
Justice Byron R. White: This isn't fiction at all.
Let's say, we're going to -- your only full basis, you're going to have to pay as soon as you take in the income and the face amount in receivables for the collected amount, except we won’t make you take an income now in certain percentage of it.
Let me take out the balance.
Mr. Matthew J. Zinn: That's right but nevertheless, there is a recovery.
If we view the partnership as a separate entity, there is a recovery of that deduction and we think that the Code --
Justice Byron R. White: In case that the -- if the corporation had never taken place --
Mr. Matthew J. Zinn: That’s right.
Justice Byron R. White: -- the partners would never pay the nickel on that $73,000.00 unless they had actually collected some of those accounts receivable.
Now, you're saying nevertheless they should pay that $73,000.00 although they have not yet received any –
Mr. Matthew J. Zinn: That's correct.
Justice Byron R. White: And they never will.
Mr. Matthew J. Zinn: That's correct.
In the case of a corporation that liquidates tax free under Section 336, and distributes all of its assets to its shareholders in liquidation, it is clear that the corporation must restore the reserve to income even though it didn't collect the amount of the reserve for bad debts.
All it's getting back are pieces of paper just like the partners are receiving here.
Justice Byron R. White: We've -- we've held that here?
Mr. Matthew J. Zinn: You haven't held it but such holdings as they are, are consistent with that and petitioners conceived that in their brief that on a liquidation of a corporation, there is a restoration of the reserve to income.
Chief Justice Warren E. Burger: Mr. Zinn, when this transfer occurred, I assume that in the eight offices of the corporation and partnership later the corporation, they had typewriters, desks, chairs and a lot of office equipment.
Let's assume just hypothetically that that equipment was worth and had an original cost of $50,000.00 and then have been depreciated down to $25,000.00.
Would you say that now that it’s transferred to the corporation that depreciation which is a hypothetical recognition or a prophesy as is the bad debt deduction should now be charged back as income to the partners?
Mr. Matthew J. Zinn: No, we would not Mr. Chief Justice but that is because Section 1245 and Section 1250 of the Code specifically so provide.
Chief Justice Warren E. Burger: Well, but the function of the bad debt loss is essentially in principle the same as the function of a depreciation for obsolescence isn’t it?
Mr. Matthew J. Zinn: They are similar although some of the cases that we have cited including the West Seattle Bank case draw a distinction between the two.
Insofar as I can understand the distinction and it’s rather murky, it is that with respect to accounts receivable and a reserve for bad debts, you cannot be certain that any particular account will become worthless, whereas you have some greater degree of assurance that wear and tear and obsolescence will gradually diminish the value of an asset.
Chief Justice Warren E. Burger: But that isn't necessarily true as a matter of reality, in a period of rising costs, it frequently occurs that assets long since depreciated down to zero become worth a great deal and then the Government on liquidation recovers that, do they not?
Mr. Matthew J. Zinn: I agree that they would and I think that they would recover it here but for the fact that we have specific statutory provisions that apply.
I think it would be helpful if I point out to the Court that in the investment credit area, the Government wouldn’t be taking a position that it’s taking here because Section 47 (b) of the Code provides that property shall not be treated as ceasing to be investment credit property with respect to the taxpayer by reason of a mere change in the form of conducting the trade or business.
Had a provision like that been included in the Code in Section 351, we wouldn't be here in Court today.
But the fact is, that Section 351 only prohibits the recognition of gain or loss and we are not seeking to tax gain or loss in this situation.
Justice Hugo L. Black: Is your argument based on the fact, somehow somebody didn't put down there what they had intended?
Mr. Matthew J. Zinn: No, Mr. Justice Black.
Justice Hugo L. Black: And that the Government is going to get this payment although it shouldn't have it but nevertheless the letter of the law doesn’t allow it?
Mr. Matthew J. Zinn: Well, our position here is that the Internal Revenue Code doesn’t tell us which way to handle this double deduction problem.
That the Commissioner has determined that the proper way to handle it is to restore the bad debt reserve to income under the tax benefit rule.
That application of a tax benefit rule here is entirely consistent with all statutory provisions and that under decisions of this Court, so long as the Commissioner’s solution to the double deduction problem is reasonable, that that is the end of the case.
Justice Hugo L. Black: Well, is it your position that in all truth and fact and justice that this is not going to require a taxpayer to pay taxes on income that he did not receive as income?
Mr. Matthew J. Zinn: Yes, but when he --
Justice Hugo L. Black: You admit that?
Mr. Matthew J. Zinn: Yes, but when he obtained the deduction for the reserve for bad debts Mr. Justice Black --
Justice Hugo L. Black: But he will have to pay income tax on income that he did not get.
Mr. Matthew J. Zinn: We say he received it because he obtained a deduction when he set up the reserve for bad debts for a loss he did not suffer.
For a loss that would be --
Justice Hugo L. Black: Then you are saying that this would be a double benefit to him?
Mr. Matthew J. Zinn: No.
No, we're saying that when he set up the reserve for bad debts, he got a deduction for a loss that he had not yet suffered and now since the partnership is terminating and since the partnership never incurred those losses, he must restore the bad debt reserve to income.
Justice Hugo L. Black: Then what happens suppose they don't collect it?
The sale turned out to be bad.
Mr. Matthew J. Zinn: We think that the corporation would be entitled to take a deduction because it would have suffered the losses.
Justice Hugo L. Black: I take it.
It would be entitled to take a deduction later?
Mr. Matthew J. Zinn: Yes, because it suffered the losses.
Justice Hugo L. Black: That's your argument as to why it's fair for the Government to pay.
Mr. Matthew J. Zinn: That's right.
The corporation is entitled to the deduction because it suffered the losses.
It actually suffered them.
The partnership here did not suffer the bad debt losses which obtained through creation of the reserve.
The reserve is an estimate of future losses and the partnership never suffered those losses and for that reason, we don't think it’s entitled to retain the benefit of the deduction.
Justice Hugo L. Black: Your argument is in fact is it that the Government would get this I mean the taxpayer would be getting this reduction twice?
Mr. Matthew J. Zinn: No, our concern is that if that -- the partnership has already gotten the deduction.
Justice Hugo L. Black: That's right.
You say it’s already gotten.
Mr. Matthew J. Zinn: There is a possibility that the corporation will get a deduction for the same accounts receivable.
Justice Potter Stewart: As I had understood your argument, Mr. Zinn, it was this that the statute itself does not explicitly tell you or the taxpayer how this situation should be handled and that your submission is that the way you handle it is a reasonable way of handling it under the statute and that that should be the end of the case and as I further understand it, neither you on the one hand, nor your adversary on the other are claiming that either, there should be double taxation or a double deduction.
You both recognize that however this is worked out, that there shouldn't be a double deduction and that these same items should not be taxed twice.
Mr. Matthew J. Zinn: That’s right, which way to avoid the double deduction.
Justice Potter Stewart: And as I understand it further, you’re not saying that the way you decided to handle this is the only proper way of doing it.
You're just simply saying it’s a reasonable way of doing it and that under the decisions, that should be the end of the case.
Am I wrong about that?
Mr. Matthew J. Zinn: That's correct, except that I would add to that that we think our way --
Justice Potter Stewart: Is the best thing?
Mr. Matthew J. Zinn: -- is more consistent with the provisions of the Internal Revenue Code, particularly those of subchapter C which this Court recognized last term and Commissioner and Gordon are very, very technical.
Justice Potter Stewart: Yes.
Mr. Matthew J. Zinn: Now, we think that Mr. Apolinsky’s arguments are very persuasive in terms of perhaps revising the Internal Revenue Code and making Section 351 read the same way that Section 47 (b) reads that if it’s so long as the same business is continuing, no income will be recognized.
Justice Potter Stewart: Right.
Mr. Matthew J. Zinn: But that's not what the Code says.
Justice Potter Stewart: I understand that.
Justice Hugo L. Black: But you don't claim it would be reasonable for the Government -- for taxpayer be denied this deduction twice.
Mr. Matthew J. Zinn: No, we don't seek to deny it twice, Mr. Justice Black.
We would allow it to a corporation.
Justice Hugo L. Black: Now, do you think it would be reasonable for them to get it twice?
Mr. Matthew J. Zinn: That’s correct.
Justice Hugo L. Black: It's just once is all the deduction they should get?
Mr. Matthew J. Zinn: Yes, and tha'’s all they seek.
Justice Hugo L. Black: And no scheme will do that whether you call it reasonable, you wouldn’t call it reasonable if it didn’t accomplish that, would you?
Mr. Matthew J. Zinn: I'm not sure I follow you.
Justice Hugo L. Black: You wouldn't call it reasonable would you if it was making this taxpayer be denied of privilege over a deduction for a loss he had had.
Mr. Matthew J. Zinn: Oh!
No, but the petitioners here didn’t suffer the loss that they are claiming.
The corporation suffered the loss and that's whom we want to allow it to.
Justice Potter Stewart: Neither side in this case is, your adversary is not claiming it is going to be taxed twice and you're not claiming that it's going to be deducted twice.
Mr. Matthew J. Zinn: At which way?
Justice Potter Stewart: It’s just which accounting matter --
Mr. Matthew J. Zinn: Which way.
Now, Mr. Apolinsky has pointed out both in his brief and here this morning that the corporation set up a reserve for bad debts on its books and therefore didn’t claim it twice.
I should point out to the Court that we have confirmed that but is extra record information.
It does not appear in the record.
I don't think it makes any difference except as a matter of tidiness.
Mr. Apolinsky also mentioned this morning that on a liquidation of a partnership, there would be no restoration of the reserve to income.
There is no case law on that question.
There is as I have mentioned earlier, a case law on the question of liquidation of corporation which indicates that there would be a restoration of the reserve and it seems to us that there would be a restoration of the reserve if this partnership liquidated.
Justice Byron R. White: What would you -- if someone bought from the partners the accounts receivable for cash at the net value, face less the amount of the reserve, I suppose the partners would be realize income?
Mr. Matthew J. Zinn: Well, they might realize.
They would realize no net income, Mr. Justice White because presumably the restoration of the reserve in the hypothetical that you posited.
Justice Byron R. White: Restoration?
You mean restoration?
Mr. Matthew J. Zinn: Yes, we think there would be restoration of the reserve.
Justice Byron R. White: And as to the fact of the income on the $75--$73,000.00?
Mr. Matthew J. Zinn: That's right.
Justice Byron R. White: Even if they -- nobody paid it?
Mr. Matthew J. Zinn: That’s right.
But then they would be entitled to a loss deduction for $75,000.00 because the basis of the receivables in their hands would be the face amount of the receivables, we think, not the net amount.[Recess]
Chief Justice Warren E. Burger: Mr. Zinn, you may pick up where you left off.
Mr. Matthew J. Zinn: Mr. Chief Justice and may it please the Court.
In the few minutes I have remaining, I should like to discuss the two proposed solutions of petitioners to the double deduction problem here.
That is the carryover solution and the adjustment of basis solution.
Section 381 of the Internal Revenue Code is the principal provision which allows for carryovers in certain transactions.
That provision does not apply to transactions such as the one here which is described in Section 351.
It applies only to certain intercorporate transactions.
In addition to the fact, the absence in Section 381 of a specific congressional authorization for a carryover, it is well established that a transferee in a Section 351 transaction is a new taxpayer and can adopt its own accounting methods and its own taxable year including in this specific case the specific charge off method of accounting for bad debts.
We think therefore that there is a real risk of a double deduction if this Court should hold that the tax benefit principle is not applicable here.
Third, we point out that Congress has been quite specific when it wanted items to be carried over in a Section 351 transaction.
Thus, Section 362 of the Code provides that the basis of property shall be carried over.
As I attempted to outline for the Court this morning a reserve for bad debts is not property similar carryover rules --
Chief Justice Warren E. Burger: Well, would you distinguish it in that respect from a depreciation reserve?
Mr. Matthew J. Zinn: No, a depreciation reserve is not property either but under Section 1016 of the Internal Revenue Code, a depreciation reserve is specifically provided to reduce the basis of the depreciable asset.
That's under Section 1016 (a) (2), Mr. Chief Justice.
There is no specific provision that is comparable to that allowing a basis reduction for a bad debt reserve.
I should also point out that in attempting to analogize a Section 351 transaction and to bring it within the spirit if not the specific language of Section 381, that Section 381 applies only to transfers of entire businesses.
Whereas Section 351 as I mentioned before the recess can apply to a transfer of an entire business as in this case or to transfer of a single asset.
Justice Byron R. White: Let’s assume that this wasn't a 351 transaction, the corporation was organized and assets were transferred to it for consideration and the corporation bought these receivables for cash.
I suppose its basis would be on face amount?
Mr. Matthew J. Zinn: That's correct.
In that case, the basis would be what it paid for it but --
Justice Byron R. White: What do you think the corporation paid for here?
Assume this wasn’t a taxable transaction, it was a nontaxable transaction.
Mr. Matthew J. Zinn: Right.
Justice Byron R. White: But it did issue stock?
Mr. Matthew J. Zinn: Well, its basis would be.
Justice Byron R. White: And receivable?
Mr. Matthew J. Zinn: But it issued stock and cash?
Justice Byron R. White: No, it issued stock and receivable.
Mr. Matthew J. Zinn: But it was a taxable transaction?
Well, then its basis would be the net value --
Justice Byron R. White: What is that?
Mr. Matthew J. Zinn: The face amount of the receivables less the reserve.
That would be the corporation's basis but that’s not the corporation's basis in this case according to the specific provisions of Section 1016 (a) of the Code.
Justice Byron R. White: Do you think the Code requires the corporation in this kind of a transaction to take into plus the receivable to be paid?
Mr. Matthew J. Zinn: I don't know if I can go so far as to say it requires Mr. Justice White.
It seems to me that the overriding principle that’s applicable here is no double deduction, the principle that this Court reaffirmed last term in Skelly Oil.
Justice Byron R. White: You mean that requirement is only a requirement if you’re right under --
Mr. Matthew J. Zinn: No, we say that the Code doesn’t specifically answer the question that’s presented here, how to avoid the double deduction.
Now, we think the better way to answer the question is to answer it by applying the tax benefit principle but if the Court says that isn’t the better way to do it, then we think that the basis adjustment should be made.
The Code just doesn't speak specifically to the point and we have to comply with the --
Justice Byron R. White: Basis would just be made, what does that do to the partnership?
Mr. Matthew J. Zinn: Well, the partnership, if the Court should hold that the tax benefit principle doesn't apply here, then the basis of the receivables should be reduced to net in the hands of the corporation so as to avoid a double deduction.
Justice Byron R. White: What -- if you're on the buying side rather on the receiving side on the corporate side and basically under the receivables that that value was the face, how would you pay any more than the true value?
Mr. Matthew J. Zinn: No, you wouldn't pay more than the true value for them, you pay the net amount.
Then your basis would be what you pay.
Justice Byron R. White: But what you're saying is that we must -- what we should do to save the corporation is to really pay the face -- for the face value for the seizable to debt and hence the transfer in stockholders actual recipient?
Mr. Matthew J. Zinn: I don't think we have to say that the corporation paid the face amount.
It seems to me that the Section 351 provides -- Section 362 provides that the basis of property in the hands of the transferee corporation shall be the same as in the hands of the transferor.
That basis at least so far as good interpretation of the Internal Revenue Code is concerned would be the face amount of the receivables.
Chief Justice Warren E. Burger: This partnership could have sold and assigned accounts receivable independently of this tax free transfer couldn't they?
Mr. Matthew J. Zinn: Yes, in our position, if it had done that would be precisely what it is here that the reserve for bad debts has to be restored to income.
Chief Justice Warren E. Burger: If they sold it for the net amount?
Mr. Matthew J. Zinn: If they sold it for the net amount and if they are entitled to a loss measured by the difference between the face amount and the net amount because that is a sale of property and on a sale of property, accounts receivable with a basis of let’s say $100.00, for a net value of 90, they’re entitled to a loss of $10.00.
Chief Justice Warren E. Burger: Would that be a wash transaction?
Mr. Matthew J. Zinn: It would be in most cases Mr. Chief Justice because accounts receivable under Section 12214 of the Code would be an ordinary income asset.
But if the accounts receivable happened to be a capital asset in the hands of the selling entity in the hypothetical that you posited, then the gain or the loss would be a capital loss and the restoration to income would be a restoration to ordinary income.
Justice Byron R. White: In here they thought of the partners that they have to take this in the income.
If they don't get any income out of it, it won’t be a title alone, the loss would be the corporation's.
Mr. Matthew J. Zinn: That's right because the corporation will suffer the loss.
I think I should point out that the purpose of the reserve method of accounting for bad debts is to better match costs against revenue just as it has been pointed out in the briefs but that purpose was never intended to provide a loss to an entity that didn't suffer it and that once we know that the partnership entity is terminated, the partnership should not wind up with any more bad debt deductions than it would have wound up would had it been on the specific charge off method of accounting for bad debts.
And had it been on this specific charge off method, it would not have gotten this deduction for future losses which it took and which we submit has to be restored to income when the partnership terminates.
Chief Justice Warren E. Burger: Thank you Mr. Zinn.
You have some time left to -- Mr. Apolinsky?
Rebuttal of Harold I. Apolinsky
Mr. Harold I. Apolinsky: Mr. Chief Justice and may it please the Court.
I think that the statement of Mr. Zinn points up the problem they have in applying the tax benefit rule realistically.
They set forth the rule but they don’t apply certainly in the taxable exchange area when there's a cash sale of accounts receivable.
The rule as set forth in their brief says you restore to income a deduction when you recover it.
Well, If you have a sale for the receivables at gross, that’s a recovery and it would come in income.
If you have a sale at net, the most logical conclusion seems to me is that you have no recovery under the tax benefit rule and therefore there’s no income to the taxpayer selling in a taxable transaction.
The Government in order to bend the rule to fit our tax free situation sets up a hypothesis that they have a loss realized on the receivables which counteracts the return to income of the reserve and the wash result is a net of zero.
We say that's an incorrect approach to the problem.
The loss occurred when the taxpayer got the deduction for the reserve.
When you set it up, that's when the deduction occurred.
The fact that later on, he sold it net was merely a realization that his estimate, his loss was correct, not a subsequent loss down the road to offset some artificial inclusion in income.
We further say that we do not agree in our brief and our brief, I think shows that, that there is a different rule to apply in Section 337 liquidations.
We don't -- I did not cover that because it’s covered in my brief but Mr. Zinn said that we did agree and we do not.
In fact, the revenue ruling in 1957 where the Government covered the liquidation under a one year liquidation rule specifically set up the hypothesis that the corporation sold its receivables at face.
And they said, therefore the reserve comes back into income.
Well, that seems to be the tax benefit rule in its proper application and I've set out that entire revenue ruling in the last page of my appendix.
I also take issue with Mr. Zinn when he disputes whether upon the liquidation of a partnership the reserve comes into income of the partners.
In my judgment, in a pro rata liquidation of a partnership under Section 736, there is no recognition of income to the partners.
I would just focus our attention if I will on the question, the Government has assumed as we said that there is a problem of a double deduction.
We maintain that there is no problem of a double deduction because there has been no, in our case, no one has tried to take a second deduction and in no case discussed today or in any of the brief has any taxpayer attempted to take a second deduction at any stage.
So that the basis hypothesis for the need for the revenue ruling it seems to me unfounded that there is not second deduction to guard against and therefore, without that problem, there’s no need to even travel under 7805 but under that Section, the solution if we were to assume for argument there’s a problem.
Under that Section, the solution has to be consistent with the statute.
We say that Section 351 which says no gain or loss if property is transferred, if, it doesn’t say from property, it’s not tied to the property.
It says if property is transferred, that the legislative history of that Section points out that that’s not a taxable event, it’s just a change of form and in 1924, Congress in reviewing it said, no gain or loss and in the next sentence, it says, this is not a time for the realization of income.
So we say there is no magic in saying what we have over here is income and the statute said no gain, loss or income because in 1924, they used the two terms interchangeably.
Certainly, the cure to the illness should not be worse than the illness itself and that’s what’s going to happen if we restore to the partnership this income.
It creates artificial tax planning.
Partners, proprietors, transfer into corporations can't put receivables into their corporations because if that mature the reserve for bad debts, they would not then have any cash to pay the income tax with.
So what's happened since 1962 is that people with reserve for bad debts have been artificially holding out their receivables, or else possibly making cash sales at nets to third parties to create what the Government says is a wash situation.
That -- and this is a recurring problem.
The Government in their petition for certiorari agrees that we have incorporations of businesses everyday and it just seems to me that we should not visit the need for some artificial planning.
Congress in 1921 said, to order, to encourage business readjustments and even spoke of artificial transactions that they were going to place this tax free environment.
The simplest thing I think is not to look to a specific solution to a double deduction, we say there isn’t or to simply for the court to remind the tax bar is we don’t need reminding of your decision of Skelly Oil.
There is just not going to be any second deduction allowed irrespective of which particular route is followed and we urge that the Fifth Circuit be reversed and that the District Court's decision be affirmed so that the partnership in this situation would not take into its income the reserve for bad debts.
Chief Justice Warren E. Burger: Thank you Mr. Apolinsky.
Thank you Mr. Zinn.
The case is submitted.