Cases by Issue - Federal Taxation

Internal Revenue Commissioner v. Banks - Oral Argument

Fri, 09 Jan 2009 14:49:00 +0000

Case:

Internal Revenue Commissioner v. Banks

Media File:

03-892_20041101-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of David B. Salmons

Justice Stevens: We'll hear argument in two cases, the Commissioner of Revenue... Internal Revenue against Banks and the Commissioner against Banaitis.

Mr. Salmons.

Mr. Salmons: Thank you, Justice Stevens, and may it please the Court:

Section 61(a) of the Internal Revenue Code defines gross income to include all income from whatever source derived.

As this Court has held, that definition is sweeping and represents an intent by Congress to exert the full measure of its taxing power.

The court of appeals decisions below, by excluding from respondent's gross income the portion of litigation proceeds paid to their attorneys under contingent fee agreements, is inconsistent with two longstanding Federal tax law principles for defining gross income.

Justice O'Connor: Now, if... if this didn't involve the alternative minimum tax, would the amount be deductible?

Mr. Salmons: Your Honor, but for the alternative minimum tax, there would be an... a miscellaneous itemized deduction--

Justice O'Connor: Right.

Mr. Salmons: --under section 212 of the code--

Justice O'Connor: Right.

Mr. Salmons: --that would be subject to the limit of the 2 percent of adjusted gross income that applies to itemized deductions.

But section 56(b)(1)(A)--

Justice Scalia: That's of annual income.

Right?

2 percent of... of the person's annual income?

Mr. Salmons: --Of the adjusted gross income.

Justice Scalia: For the year.

Mr. Salmons: For the year.

That's correct, Your Honor.

Justice Scalia: But, gee, in the case of a... of a major award, that 2 percent is very likely to be exceeded, isn't it?

Mr. Salmons: It... it certainly may, Your Honor.

Justice Scalia: So this is a problem that's going to exist even... even after the alternate minimum tax is abolished.

Right?

[Laughter]

Mr. Salmons: I'm not sure entirely what you're referring to as the problem, but it is the case that... that--

Justice Scalia: Well, you don't think... the Government doesn't think it's a problem.

I'm talking about taking a huge percentage of the... of the person's recovery.

That... that will happen even... even in the case where there's no minimum tax... alternative.

Mr. Salmons: --That is correct.

That... that is correct, Your Honor.

Now, I mean... and let me make two points about that.

The first is that as a... as a general matter, the tax code defines gross income expansively, and there's a number of this Court's cases that make that clear.

Then... then the question becomes are there deductions provided that allow for certain expenses to be deducted.

Justice O'Connor: Don't some States such as Oregon require a plaintiff to remit a portion of punitive damages recovered to the State so they don't even go to the taxpayer?

But is the taxpayer saddled with that too?

Mr. Salmons: Your Honor, I would think the answer to that question is no.

It's not a question that I have examined in depth in... in this case because it's not presented, but as a general matter--

Justice O'Connor: Well, what about attorney's fees in class actions?

As I understand it, those are not regarded by the Government as attributable all to the taxpayer.

Mr. Salmons: --Your Honor--

Justice O'Connor: A plaintiff who's part of a class in a class action suit where attorney's fees are paid.

Mr. Salmons: --Your Honor, we believe that the same principles would apply to class action lawsuits as to other lawsuits in terms of the taxation of litigation proceeds.

It may very well be the case in a number of class action contexts that when applying those principles, the proper... the proper analysis leads to the conclusion that the taxpayer doesn't exert sufficient control and that the payment of attorney's fees is not in response to a debt owed by the taxpayer.

And so there might be a different result.

Justice O'Connor: Well, I... I thought we were... our attention was pointed to a number of instances where the Internal Revenue Service did not require the taxpayer to show all the attorney's fees as income in those class action situations.

Mr. Salmons: Your Honor, that is correct.

Justice O'Connor: Yes.

Mr. Salmons: I want to be clear.

We think the same principles apply across the board to defining gross income.

In applying that in a number of class action contexts, the proper answer may be that it's not included in gross income because there wasn't sufficient control and because it wasn't paid in... in lieu of a debt owed by the taxpayer.

But here--

Justice Souter: Why... why isn't there as much control in each case?

I mean, the... somebody goes to a lawyer with a claim and says, press the claim for me, recover if you can.

What's the difference in... in terms of control?

So that if you win this case, why doesn't it apply to class action?

Mr. Salmons: --Again, the principles would apply and there may very well be class actions--

Justice Souter: Yes, and I... I want to know why the result would be different.

Mr. Salmons: --Again, I'm... I'm trying to be as specific as I can.

There may be situations in which, even in the class action context, there's a fee agreement between the... the class member and the lawyer so that the payment of attorney's fees is in satisfaction of a debt owed by the class member, and in that situation we think that it would be--

Justice Souter: Why... why would... why would that analysis appear?

Certainly there's... there's not going to be any fee paid in the... in the paradigm example of the class action without a recovery.

Mr. Salmons: --That's correct, Your Honor.

There... there are situations--

Justice Souter: So we're in the... so we're in the situation we're in right now, aren't we?

Mr. Salmons: --We are in the situation in which there's a need to apply the general principles for defining gross income.

Justice Souter: All right. But let me just... I'll just press the point one more time.

I don't understand, based on what you've said, why the class action result would be different from the result that you're arguing for here if you win this case.

Mr. Salmons: And... and what I'm trying to point out, Your Honor, is that there may very well be class actions where it's not different.

There may be some when... where it is if it's the case that there's no contractual obligations to pay the fee... pay the fee between the class member and the attorney, and if it's the case that the class member really exerts no meaningful control over the... over the attorney's fees portion--

Justice Breyer: I thought the class action distinction that the commissioner had was between opt in and opt out.

Mr. Salmons: --That is certainly one of the factors that... that the commissioner has looked to in those class--

Justice Breyer: So if you opt in, then you did exercise control.

So all the money is yours.

But if you opt out, you didn't have control over the suit because you didn't opt out.

I mean, you just were lethargic.

Mr. Salmons: --Again, those are all facts--

Justice Breyer: That's the basic thing.

I mean, I'm trying to understand what the principle is for the reason that it's pretty hard for me to reconcile the commissioner's view in the class action case with the punitive damage case because there the person has control over the lawsuit.

So why doesn't all the punitive damage, attorney's fees that come out of that, and so forth belong to... in other words, it sounds to me, as I read this, something of a mess, and I'd like to know what the clear principle is.

Mr. Salmons: --Yes, Your Honor.

And... and just to be clear, I... I don't think the commissioner has ever taken the position that all class actions don't present the... the possibility of the attorney's fees portion of the award being included in... in the class member's gross income.

Now, there are real enforcement issues, as a practical matter, to trying to... to trying to implement that.

You can imagine a number of class actions--

Justice Ginsburg: When you say the class member, do you... you mean the named representative.

The class may include thousands of people, but it would be income to the named representative?

Is that--

Mr. Salmons: --Well, presumably, Your Honor, that... only the portion of the attorney's fees that would be attributable to the... the named representative's recovery would be included in the named representative's gross income.

I don't think that the named representative would be on the hook, if you will, for all of the attorney's fees that would relate to other class members' recoveries.

But I think what all this points out is that--

Justice Ginsburg: --Well, then... then would it be... would the income then go to each class... would each class member have a share of the income?

Mr. Salmons: --In a number of instances, yes, Your Honor.

Again, the... the way that we think that class action cases should be resolved is the same way that... that these issues are approached in all cases, which is to look at the type of relationship that exists between the... the client and the attorney to see whether the payment is made in... in response to a debt owed by the client and also to look to the degree of control that the client has over the... the underlying source of income.

And in this context, it is--

Justice Scalia: Suppose... suppose the same amount were paid, as was paid here, to the attorney, but it was not by way of a contingent fee, that the... the client had committed to pay this dollar amount in a dollar amount.

Mr. Salmons: --As a flat fee?

Justice Scalia: As a flat fee.

What... what would the tax treatment of that be?

Mr. Salmons: Your Honor, I think in fact it is undisputed in... in the... in these cases that if the payment of attorney's fees had either been under an hourly rate arrangement or a flat fee arrangement, that the entire amount of the litigation proceeds would be included in the... in the respondent's gross income and nothing about the contingent fee arrangements here should... should alter that result.

The respondents--

Justice O'Connor: Well, let... let me ask you about Professor Davenport's theory.

He filed a... an amicus brief here saying that the contingency fee or the attorney's fees should be capitalized as a transaction cost increasing the basis of the property which was the claim in the lawsuit.

Mr. Salmons: --Your Honor, I'm trying to recall that amicus brief.

I believe that... was that an argument, I believe, about the application of section 83 of the tax code when you have a transaction--

Justice O'Connor: Yes.

Mr. Salmons: --in exchange for services and you provide property?

Justice O'Connor: Yes.

Mr. Salmons: We think that the better way to analyze this is that in fact there was no transfer of the underlying cause of action, and so we think that... that we... that gets into a very complicated area as to how you value the attorney's fees at the time.

Justice Scalia: Well, you... you don't need a transfer of the... I don't understand what you mean--

Justice O'Connor: No, I don't either.

Justice Scalia: --a transfer of the... the cause of action.

Certainly if you buy a piece of real estate and... and there's lawyer's business connected with it, you... you don't... you don't take an ordinary deduction which is subject to the alternative minimum tax for those lawyer's fees.

You just say that's part of the transaction, and it goes onto the basis of your property.

Right?

Mr. Salmons: I believe that's correct, Your Honor.

But the point I was making--

Justice Scalia: Why isn't... why isn't that very similar to this?

I mean, what difference does it make whether there's a... there's a transaction here, isn't there?

Isn't there a transaction?

Mr. Salmons: --Well, there is an agreement to pay a fee for a service, and in that sense there is a transaction, yes.

Justice Scalia: Yes, but a... the service is connected to a transaction, namely the conversion of the chosen action into a money payment.

You have this--

Mr. Salmons: That... that is correct.

Justice Scalia: --this unformed chosen action.

You're entitled to it, but there's a transaction converting it into a money payment.

Now, why shouldn't you attribute to that transaction all... which is profitable to you, all of the costs that go along with the transaction?

Mr. Salmons: Well, again, Your Honor, we think that transaction is essentially identical to numerous transactions that take place every day out in the real world where... where taxpayers retain professional services in exchange for a commission or a percentage of the income that's generated.

Justice Scalia: That is a problem that occurs to me.

I don't know where you draw the line.

And you say you can't draw a line.

Mr. Salmons: That is absolutely correct.

I don't see any basis for distinguishing between--

Justice Ginsburg: How does it work?

Mr. Salmons: --the attorneys here and... and a... and an agent negotiating a book contract for an author or a financial analyst.

Justice Ginsburg: You... on that, that example, you gave the book contract with the author and you gave, I think, the investor.

Would this problem arise in those cases or would the author get an above-the-line deduction?

Mr. Salmons: No, Your Honor.

I believe that the author in those... in that situation would receive the same deduction that prior to the enactment of section 703 of the American Jobs Creation Act where Congress just addressed in part the... the issue raised in these cases--

Justice Ginsburg: So you say the author... that these people are all in the same--

Mr. Salmons: --They would have an itemized... excuse me... a miscellaneous itemized deduction for the cost incurred in... in producing income that under the alternative minimum tax would not be allowed.

Justice Kennedy: Is there any argument... you... you said at the outset that it has to be an itemized deduction subject to the 2 percent rule even if we set aside the alternative minimum tax.

Is that conceded by everyone, or does somebody... do some people say this is an ordinary and necessary expense?

I know it's not your business, but it seems to me an ordinary and necessary expense to recover the... the... for employment discrimination, which is really part of your work.

I don't know why... is it... does everybody agree that this is subject to the 2 percent rule?

Mr. Salmons: I will... I will have to allow respondents to speak for themselves to that question, but as far as I'm aware, that is not in dispute in these cases or in any of the cases that have been litigated that... that but... that but for the alternative minimum tax, the way this would have been handled is that there would have been a miscellaneous itemized deduction under section 212 of the code for the cost incurred in producing income, and that the alternative minimum tax, along with, by the way, a large number of other perfectly valid deductions, get disallowed under the alternative minimum tax.

Justice Kennedy: I... I can't get out of my mind in this case that the mechanics of the particular case may control.

I know we need a national rule and so forth.

My recollection is that in some States when there is a settlement or a judgment paid under a case where there's a contingency fee contract, the check is made out both to the attorney and to the client and is put in the attorney's client's trust account.

So the client never has control over it.

Mr. Salmons: Well--

Justice Kennedy: Let's assume that that's true in most of the States.

Mr. Salmons: --That... that... I know that were... that was the facts, Your Honor, in the... in the Banks case, that there was a check made out to both.

In fact... in fact, there was--

Justice Kennedy: So in a very real... in... in a very real sense, in a... in the legal sense, the client just doesn't have control.

Mr. Salmons: --Well, Your Honor, we disagree with that for, it seems to me, at least three reasons.

The first is that at the time the client entered into the fee agreement, he certainly had control then.

He had complete control over his cause of action.

He was--

Justice Kennedy: Well, he... he did or he didn't, but there was no money there.

There was nothing there.

Mr. Salmons: --Well, there was an entitlement to recover.

Now, there might have been a dispute as to the proper amount or whether that claim was valid, but he was entitled to recover based on the injury he suffered that was cognizable at law and that gave raise to a cause of action.

Now, in exchange for legal services, he promised to pay a portion of the recovery to the lawyer.

That is a promise to pay a fee.

That is not an assignment or any other transfer of the underlying cause of action.

And it is undisputed, I think--

Justice Souter: Mr. Salmons, doesn't the plausibility of your argument here rest on the assumption that what the... that the cause of action at the time the... that the plaintiff made the agreement with the lawyer is a cause of action which has the same value as the ultimate recovery that the lawyer gets?

Whereas, in fact, the cause of action at the time of the agreement with the lawyer has an inchoate value.

The... the value that is actually realized is going to depend in part on the... on the skill and... and the... the gumption of the lawyer.

So that the... what I'm getting at... and... and going to Justice Kennedy's question, it seems to me that the value realized as opposed to the right to sue are two different figures.

And I don't see realistically how the client has complete control over the value realized, which we don't even know until the lawyer has done his work and gotten the check.

Mr. Salmons: --Your Honor, two responses to that question, if I may.

The first is that, as a matter of law, it is the client that controls the cause of action and throughout the time period, even after they... they enter into an... a contingent fee agreement, it is the client that owns and controls the cause of action and he decides whether to settle.

He decides whether to press forward or withdraw the case.

He decides whether to fire the lawyer or not.

He is a... he controls the source of the income.

Therefore--

Justice Ginsburg: --Even... even the potential lawyer's fee.

I mean, suppose this client has a major dental repair and he's got a risk-taking dentist, and he says, dentist, I'm going to give you a deal.

I know you like to take risks.

I may win big in my lawsuit, in which case you get everything; and I may lose, in which case you get nothing.

The dentist says, fine, I'll take it.

Can the client in that agreement with his dentist give what will be the lawyer's fee, the part that will go to the lawyer under the contingency fee agreement?

Mr. Salmons: --Well, presumably, Your Honor, if he's already... he's already promised that to the attorney, he would be in violation of his agreement with the attorney if he did so, and his attorney could sue him to recover or the dentist could sue him to recover.

Justice Ginsburg: Then he doesn't have... then he doesn't have dominion over that portion.

Mr. Salmons: Well, because he's... he's given it away.

In that sense I think... and... and in answering this, if I may just go back to one point that Justice Souter made and that is that I don't think it's the case that our analysis turns at all on how you value the claim, either at the time of the fee agreement or afterwards.

Our analysis says at all relevant times, regardless of whether the value changed or not, the client was at all times in control of the underlying source of income, and it's just as if in Helvering v. Horst the father assigns the... the bond coupon to his son, but he controls the underlying source of income.

Justice Souter: No, but the bond coupon has a certain value at the time the father assigns it.

Mr. Salmons: That's true.

Justice Souter: The only thing that has to be realized after the assignment of the coupon is the passage of time at which it will be payable.

Here we do not have a definite value.

We don't know... there's no way to know for sure what the value will be until the lawsuit is over with.

The... the two are not comparable.

Mr. Salmons: Your Honor, that would be equally true of an assignment of a stock dividend while I retain the stock.

I may not know what the dividend payment is going to be, but if I control the underlying source of income, i.e., the stock, then the transfer to someone else of the dividend doesn't alter the incident of tax, even if it's unknown.

And I would point out that in Lucas v. Earl, the husband and wife in that case entered into agreement to assign to each other 50 percent of their income in 1901, long before the income tax was even instituted, and the tax years at issue in that case were 1920 and 1921.

If anything, it was much more speculative and uncertain what income would have been earned 20 years later in that case, and that did not stop the Court from--

Justice Scalia: So you're... you're--

Mr. Salmons: --applying this principle that--

Justice Scalia: Can I... can I ask you a question relating to the Davenport... what's been referred to as the Davenport theory?

I had thought that... that the service has used the... the transaction theory with regard to legal fees payable for a lawsuit seeking increased compensation for the condemnation of real estate where the taxpayer had objected to the amount that the condemning entity was offering and brought suit in court and with a contingent fee to the lawyer and that the service treated that as... as part of the transaction cost.

Am I wrong about that?

Mr. Salmons: --Your Honor, to my knowledge, the... the IRS has had a consistent position that the entire amount of litigation proceeds, including the amount that may be paid to a lawyer under a contingent fee agreement, even in the condemnation context, is... is included in the gross income of... of the taxpayer.

And I would point Your Honor to the case out of the Federal Circuit, Baylin v. United States.

That case involved a condemnation action, and the court of appeals in that case addressed the issue that's presented in these cases and concluded that it was includable in gross income.

Justice Scalia: Maybe my recollection is wrong.

I'll look again.

Mr. Salmons: And... and I would point out, Your Honor... and this has to do, I think, with the impact of the new legislation that's been pointed to in the supplemental briefs... that at least six of the court of appeals cases addressing the issue presented in these cases involved claims that would not be covered under the new section 703 because they... they don't involve claims for unlawful discrimination or... or FCA claims or certain Medicare claims--

Justice Breyer: --But can... can I ask you to go back for a minute?

I guess the IRS... you're seeing the lawsuit as the income-generating asset.

Mr. Salmons: --That's correct, Your Honor.

Justice Breyer: And you're looking at the control of the plaintiff, for example, over the lawsuit as something that determines whether it's his income.

And he, of course, can't give away his income.

But on that theory, to go back to Justice O'Connor's original question, then the punitive damages also must be his income because he has equal control over them and they grow out of the income-producing asset.

And that, of course, is what's bothering me because it seems to me that your theory, which is a well-established theory, coupled with a Congress that seems to be willing to take away deductions for expenses that lead to the income, could produce an income tax that in many cases, not just a few, exceeds the income that an individual has.

And I would like to know what in the law is there to guard against that result.

Mr. Salmons: Well, Your Honor, I guess my response to that is that, first--

Justice Kennedy: Other... other than the mercy of the Internal Revenue Service.

[Laughter]

Mr. Salmons: --Your Honor, the fact of the matter is, is that Congress has looked at... at this issue, and in the new section that I just referred to, section 703--

Justice O'Connor: Well, but does that happen?

You haven't the question.

Are there instances where plaintiffs in lawsuits end up receiving tax bills, as a result of this scheme, for more money than they received in the lawsuit?

Mr. Salmons: --That has occurred, Your Honor.

Justice O'Connor: Yes.

Mr. Salmons: And... and Congress responded to concerns about that very result--

Justice Kennedy: Well, but doesn't... doesn't that indicate--

Mr. Salmons: --in the new section.

Justice Kennedy: --something basically flawed about your whole theory?

Mr. Salmons: No, Your Honor.

It is--

Justice Kennedy: This is not income in any... in any real sense.

Justice Breyer: Is there any constitutional protection?

The Sixteenth Amendment refers to an income tax, and perhaps that doesn't include a tax that grossly exceeds in many cases a person's income.

That would be quite a far-out theory at the moment.

Mr. Salmons: --I think it would be, Your Honor.

Justice Breyer: But I... that's why I ask you.

Is there any protection in the law whatsoever?

Or if Congress decides to tax a set of people who, let's see... say, earn $10,000 a year and because they're small business people, they happen to have $20,000 expenses.

So it taxes them on $20,000, and the tax exceeds the income.

There's no protection in your view against that result.

And you just said, well, Congress decided to do it, it decided to do it.

Mr. Salmons: But we do think, Your Honor, that the only limit on Congress' taxing authority would be the Constitution, and I don't see a constitutional violation in disallowing a deduction, but--

Justice Breyer: What about an assumption, for example, that when we read the code, we read it with a view towards thinking Congress did not want to produce such unfair results?

Mr. Salmons: --Your Honor, if I may.

The way I would respond to that concern is that the proper way to address it is not as the courts below did and as respondents urge, to alter or distort the general definition for gross income under the... under the tax code which may have broad ramifications in a number of areas outside of this one, but to go to Congress, as in fact people have done, and to get them to make... make additional deductions or otherwise alter the alternative minimum tax, which generates the primary concern I think at issue in these cases.

Justice Ginsburg: What happened in the cases--

Mr. Salmons: That's the proper way to handle that.

Justice Ginsburg: --There were cases... we don't have to deal in hypotheticals.

There were cases where this happened, where people ended up liable for a tax greater than what they took in.

What happened in those cases?

Mr. Salmons: They were... they were liable for a tax greater than what they took in.

Those were pointed to Congress--

Justice Ginsburg: I mean, there was one that was $99,000, if I remember right.

Mr. Salmons: --I believe that's correct.

Those were pointed out to Congress and that was part of what motivated Congress--

Justice Ginsburg: Was there a private bill?

Mr. Salmons: --to enact section 703 to protect--

Justice Ginsburg: Or what happened?

What actually happened in that case, do you know?

Mr. Salmons: --I do not know, Your Honor.

My... my understanding is that the tax was assessed and I don't know whether--

Justice Scalia: Mr. Salmons, I... I... you've cited the... the Baylin case to me and I... I've looked at the description of it in the brief, which I had recalled, and what it says is that it did, indeed, involve a taking by the State, and when the State didn't offer what Baylin thought was... was enough, he went to court, he prevailed, and recovered a much larger sum than the State had offered him.

His legal fees were, by the IRS, subtracted from the award, and he was taxed only upon the proceeds reduced by the legal fees.

Now, how do you explain that situation there?

Mr. Salmons: --Your Honor, if I--

Justice Scalia: And how does that--

Mr. Salmons: --misremembered that case, I apologize.

My... my recollection was that... was that the court in that case had included the attorney's fees in gross income.

But... but--

Justice Scalia: --I doubt... I doubt whether Professor Davenport has misdescribed the case in... in his brief, but I--

Mr. Salmons: --But... but again, Your Honor, if I may.

I think the... the basic point to recall here is that the definition of gross income cuts across the tax code.

If there are concerns about application, then the proper result is to go to Congress, as has been done.

Congress has addressed the very concerns cited by respondents and the amici in this case, and that specifically is the... the application on civil rights plaintiffs.

Justice O'Connor: Does the Fifth Amendment Takings Clause apply to a Government tax scheme that taxes something beyond the income received?

Mr. Salmons: Your Honor, it... there may be... there may be a takings issue at some point.

Again, there may be constitutional limitations.

Justice O'Connor: Well, at the point where the Government charges more than the taxpayer received--

Mr. Salmons: But I think, Your--

Justice O'Connor: --in income?

Mr. Salmons: --Your Honor, I think when... when what you're talking about is how to define--

Justice O'Connor: I mean, this is an appalling situation.

Mr. Salmons: --Again, Your Honor, I... I think as a general matter, the... the proper definition of gross income would include the attorney's fees portion of litigation awards.

It's important to note that the when Congress--

Justice Souter: What... what do you we make of the fact that two Senators apparently don't agree with that position?

I mean, I... I'm referring to the colloquy that was quoted in... in one of the... the briefs about the recent legislation, and the... the substance of the colloquy was we're not making any change in the law, we're just clarifying it.

Well, in fact, if there is no textual difference for tax purposes between the law, so far as it concerns these... these so-called discrimination recoveries and non-discrimination recoveries that have the same problem that Justice O'Connor is talking about, shouldn't we infer that at least the Senate of the United States assumes that this does not get into gross?

Mr. Salmons: --No, Your Honor.

In fact, what I would say is that the thing to focus on is what Congress actually enacted and it makes clear that all the litigation proceeds--

Justice Souter: I'm... I'm talking about the colloquy.

I'm talking about the colloquy.

Mr. Salmons: --I... I understand that, Your Honor, and what I'm trying to answer is that the... the legislation itself makes clear that it's included in gross income and an above-the-line deduction is provided, and that the colloquy was referring to a prior version of the bill that would have been retroactive in part.

The new bill is not retroactive, and we think it's clear that it does work a change because from, among other reasons, it's undisputed that if these fees had been paid on an hourly fee basis, they would have been included in gross income and... and the alternative minimum tax would apply.

Justice Scalia: --We don't really know who prepared that colloquy anyway, do we?

Mr. Salmons: We do not.

Justice Scalia: It might have been prepared by the respondents here.

Mr. Salmons: We do not.

[Laughter]

If I may reserve the remainder of my time.

Justice Stevens: Mr. Jones.

Argument of Philip N. Jones

Mr. Jones: Thank you, Justice Stevens, and may it please the Court:

My client and I are asking the Court to rule that the assignment of income doctrine does not apply when unrelated persons combine their resources to jointly generate income.

And we--

Justice Kennedy: What... so what... what about the talent scout who tells the celebrity that he'll take 10 percent of the celebrity's movie proceeds or the management search person that's going to take a... a third of the executive's pay for the first 6 months?

Where... are all... all these cases ones in which there... there's no income to the... to the principal, we'll call them?

Mr. Jones: --You mentioned the... the management agent and the... I think you mentioned the talent agent, and there was also mentioned the literary agent.

The... the author is in the trade or business and gets to deduct all this off the top.

There's no problem there.

Justice Ginsburg: That's the... that's the question I asked Mr. Salmons--

Mr. Jones: Yes.

The literary agent--

Justice Ginsburg: --and he gave me the opposite answer.

Mr. Jones: --Yes.

The literary agent is in a trade or business.

That's off the top.

That's an ordinary and necessary business deduction on Schedule C.

Justice Breyer: And that isn't the question.

Mr. Jones: Yes.

Justice Breyer: The... the problem is you're... you're trying to get a theory in response to him that I think Justice Kennedy is asking about.

Mr. Jones: Yes.

Justice Breyer: And that theory, which is the problem for your side of the case... that theory has all kinds of implications.

I go out and I help the painter paint my office.

We have a joint venture.

I... so there's no problem.

I don't take it in... you know, I get a... this is great.

And so that I think, if I'm right, was the thrust of Justice Kennedy's question.

Mr. Jones: Our first choice, our preference for this Court to rule is... is not the partnership or joint venture theory.

Our first choice is for this Court to simply look at the application of the assignment of income doctrine and ask it... if it is being misapplied.

The... the petitioner has not cited to the Court a single, solitary case in which unrelated persons combine their resources to jointly produce income, and that is the rule of law I'm suggesting to the Court today.

That is apart and separate from the partnership theory, that two unrelated persons who join together to produce income--

Justice Scalia: It's a partnership theory when you talk about two persons joining together.

I don't like this... this gold mine view of litigation, that it's, you know, like two prospectors.

You know, there's money to be obtained.

[Laughter]

Mr. Jones: --I--

Justice Scalia: That's... that's not what I view of a chosen action as.

I view it as a legal right--

Mr. Jones: --Yes.

Justice Scalia: --that the person is entitled to money, and ultimately the amount he's entitled to is determined by the litigation.

And I'm not about to adopt a... a legal theory that... that views this as a... as a search for buried treasure--

[Laughter]

--in... in which the... the lawyer and the person who has been wronged are... are simply co-prospectors.

I... I just think that that's--

Mr. Jones: Well, the--

Justice Scalia: --Maybe that's how you view the... the enterprise--

Mr. Jones: --I would like to--

Justice Scalia: --but I don't think the law does.

Mr. Jones: --I would like to suggest to the Court three avenues to reach this result that I have just suggested and the partnership/joint venture theory is only one of those.

Justice O'Connor: Well, let's move on to something else because I have a couple--

[Laughter]

Mr. Jones: Okay.

I will move on to that, and I will not mention that again.

[Laughter]

This Court created the assignment of income doctrine.

Congress did not create it.

This Court has every right and power to limit its... its definition, to limit its scope to keep it from being misapplied.

In every case cited by the petitioner, we have a... a family situation, related people making gifts to each other with no commercial purpose.

Apart from the partnership and joint venture theory, if we simply say that this case is dramatically outside of the scope of that doctrine, of good doctrine that has been applied properly in an inter-family situation, but when you have two unrelated persons joining forces to produce income--

Justice Stevens: Would you have a different result if they were related?

Supposing the lawyer is a cousin of the client.

Mr. Jones: --This Court has a long history of recognizing--

Justice Stevens: Or a good friend.

Mr. Jones: --of recognizing sham transactions.

Justice Stevens: Well, it's not a sham transaction.

You just happen to be related.

Mr. Jones: All right.

Justice Stevens: And I'm just wondering if that--

Mr. Jones: I would like to focus on the gratuitous nature of the cases relied upon by the petitioner and the non-gratuitous aspects of our case.

Let's talk about a person injury case where this problem does not arise because there's no tax involved.

This relationship of a contingent fee is entered into thousands of times every week by people injured in automobile accidents.

They are not entering into this contingent fee agreement for tax purposes.

They're not trying to avoid tax... taxes.

The commissioner is confusing intent with--

Justice Souter: All right.

On... on that theory, that there is a non-tax economic purpose, do you still maintain that your theory should have as an element unrelated people?

Mr. Jones: --I--

Justice Souter: Why do we need the question of the relationship, which Justice Stevens's questions raised, even to arise if... if the principal criterion is going to be economic non-tax purpose?

Mr. Jones: --I agree completely.

I was trying to emphasize the... the intrafamily gratuitous nature of those cases, but I agree--

Justice Scalia: There was no avoidance motive in the--

Mr. Jones: --Yes.

Justice Scalia: --granddaddy of all cases.

The assignment there, although it was between family members, had been made before there was an income tax.

Mr. Jones: But we must--

Justice Scalia: The income tax didn't exist.

There... there couldn't conceivably have been an avoidance motive.

So... so our holding could hardly be based upon... upon the existence of an avoidance motive.

Mr. Jones: --I'm asking the Court to skip over motive and look at result.

The Court in that case was attacking a result because that arrangement stayed in place after the income tax was... was enacted.

The Solicitor General is confusing intent with result.

In every case, in every single case, without exception, this doctrine has been applied to the result.

Justice Stevens: --Yes, but what if you had the same result but... in terms of the sharing of the expense and the recovery, but it was computed on an hourly basis rather than a percentage basis?

Would that produce a different result?

Mr. Jones: It would produce a different result.

The commissioner's case is based on could have.

They say they could have tried the case himself.

He couldn't.

But... but the main thing he--

Justice Stevens: No, but he could have made... I'm saying he could have said to the lawyer, I'll pay you 30... a... a third of the recovery or I'll pay you $100 an hour.

Mr. Jones: --Well, he--

Justice Stevens: And they come out exactly the same result, but you... but do you treat them differently or the same?

Mr. Jones: --We treat them differently simply because he didn't.

I practice law in a partnership.

I'm taxed accordingly.

I could... I could be... set up my arrangement different ways and the tax results would be different.

We must honor these relationships--

Justice Scalia: What is different?

Justice Stevens: Well, may I ask one--

Justice Scalia: What is different?

Justice Stevens: --May I ask one other hypothetical?

Supposing that the agreement on the contingency is postponed until the middle of the preparation, not made at the outset, but along the line, they say we'll figure out what a fair percentage will be, and when the recovery comes in, they then decide, okay, you take a third.

What... what result do you do in that case?

Mr. Jones: --I... I have difficulty with that question.

Justice Stevens: But I'm sure it arises fairly often.

Mr. Jones: My... I believe that attorneys don't allow themselves to be placed in that position.

They get the contingent fee agreement signed when the... the--

Justice Stevens: Well, I did very often.

Mr. Jones: --But I don't know the answer to your question.

I... I don't know that.

But an... we... the Internal Revenue Code respects people who enter into corporations, who enter into joint ventures, who enter into sole proprietorships, who hire employees or allow themselves to be hired by others.

Those relationships are all respected and honored by the Internal Revenue Code, and the commissioner is asking you to dishonor this relationship because Mr. Banaitis could have handled the case himself or could--

Justice Kennedy: I think probably what's... what's one of the problems here is that the reason this is income is it relates to employment.

And I don't see why hiring the attorney to get that income is not an ordinary and necessary business expense under what used to be section 162.

That may be part of the problem.

Do you agree that it's not an ordinary and necessary business expense?

Mr. Jones: --I believe the problem is that a plaintiff has... I wish I could say this plaintiff is in... engaged in a trade or business and can deduct it or trade or... as a trade or business expense.

Justice Kennedy: I mean, I suppose that's the reason... that's the reason why it's taxable to begin with, is it relates to employment.

If I hire an attorney because I'm wrongfully discharged and I get... I get my job back, it seems to me that's an ordinary and necessary business expense.

That... that's why... one of the reasons I have problems with this.

Mr. Jones: I understand.

But one of the... the odd result here of a person having to pay more in taxes than they recover... this actually comes up under a fee shifting statute that applies to the Internal Revenue Service where a person could be in litigation with the Internal Revenue Service, the Internal Revenue Service becomes obligated to pay fees because they acted unreasonably.

They pay those fees, and then they simultaneously hand the taxpayer a bill for taxes on those fees.

Justice Kennedy: Well, let me get... get to a different point.

It... it does seem to me that we... we have to be very careful in this case not to distort the revenue law for other transactions that are not before the Court.

And the... the natural extension of... of your position is that anytime when the taxpayer enters into an agreement with an agent to pay the agents an amount contingent on the success of the venture, that it's not income, that... that the... that the payment is not income to the principal.

And I just can't accept it.

Mr. Jones: No.

That is not my position.

My position is that the assignment of income doctrine does not apply.

Those relationships are all governed by existing law and there is a large body of law dealing with those cases and they can be found in a cite that is offered by the petitioner at page 3 of his reply brief.

It talks about the literary agents.

It talks about the... the management agents.

Justice Kennedy: But what's the difference in principle.

I don't understand the difference in principle when we're talking about who has the income.

It's the first thing you ask in... in a first-year... in... in your... in your first class in tax.

Where is the income?

Who gets the income?

Mr. Jones: I... I am not trying to avoid your question, but I'm trying to clarify that I am not asking this Court to determine who has the income in those cases because there is a large body of law and a large body of statutory law that answers the questions for each of those examples.

All I'm suggesting is that we do not get to those answers.

We should not get to those answers through the assignment of income doctrine.

Justice Breyer: What's your third?

I just don't want you to miss your third.

You have the joint venture theory, an exception to an assignment in income, and you said you had a third.

Mr. Jones: The Oregon question, Your Honor, which I don't think the Court is likely interested in--

Justice Scalia: The who?

Mr. Jones: --The... the Oregon question.

Justice Scalia: The Oregon question.

Mr. Jones: The Oregon question.

That is--

Justice Scalia: What is the Oregon question?

Mr. Jones: --The Oregon question is part IV of our brief beginning on page 31 which would not be a national uniform rule.

But what we're asking this Court to do is simply, as narrowly as possible, to limit the assignment of income doctrine and do nothing more than that.

Justice O'Connor: Well, what do you make of Professor Davenport's proposal to capitalize the contingency fee as a transaction?

Mr. Jones: I believe Professor Davenport is completely correct.

I support his theory wholeheartedly.

We didn't make that argument because we believe the limitation on the assignment of income doctrine is the real issue and we believe that is the narrower issue.

Justice Breyer: Well, if you took a settlement... his theory, I take it, was seeing the lawsuit as a capital asset.

Is that right?

Mr. Jones: Yes.

Well, I... I think so.

Justice Breyer: Well, then whenever you settled a lawsuit, it would be... you'd have to pay capital gains instead of ordinary income.

Mr. Jones: I... I'm sorry.

I think I misspoke.

I'm not sure that's his theory.

I'm not certain, and I'm--

Justice Scalia: I'm sure it's not his theory.

He... he thinks it's... it's attached to transactions, and... and much of his argument is devoted to showing that capital transactions are no different from other transactions as far as the Internal Revenue Code's desire to match the... the gain with the expenses concerned.

And that's the part of his theory that I'm not so sure about because aside from the... aside from the condemnation case that I mentioned, I... I don't know of any other cases in which the Internal Revenue Service has treated transaction costs the way he would have it done.

Maybe it makes sense, but I--

Mr. Jones: --I would like to make one additional point in the few seconds I have left.

The... the Solicitor General is arguing that the language, the statutory language, of the new statute implies a particular result.

This Court decided as early as 1940 in the Higgins v. Smith case when the commissioner made the exact same argument, and this Court said... and I quote... that does not follow.

The statutory language says that to the extent this income is... this... this money is included in income, to the extent it is included in income... it doesn't say whether it is or not... then a deduction will be allowed.

And that as neutral a statement as I can think of.

There is nothing in the statutory language that implies one answer or the other.

But I emphasize to the Court that the... the commissioner is confusing intent with result when he discusses the cases upon which he is relying.

Those cases reached a result and they corrected that result.

We don't have an abuse in this situation.

And the assignment of income doctrine should not be stretched beyond its bounds by this Court.

It should be limited to its historical use.

This is a misuse.

Thank you very much.

Justice Stevens: Thank you, Mr. Jones.

Mr. Carty.

Argument of James R. Carty

Mr. Carty: Thank you, Justice Stevens.

Neither section 61(a) nor any other provision of the Internal Revenue Code expressly requires that a Federal civil rights litigant, such as Mr. Banks, include in his gross income the portion of a litigation recovery that was earned by, retained by, and already taxed to his attorney as a contingent fee.

The commissioner's position in this case relies exclusively on the misapplication of a judicial doctrine known as the assignment of income doctrine.

That doctrine originated and developed as a judicial anti-abuse rule, designed to prevent high-bracket taxpayers--

Justice Scalia: No, it didn't.

Mr. Carty: --I respectfully--

Justice Scalia: It... it originated in a case where there could not possibly have been an... an intent to abuse because the... the transfer had occurred before there was any income tax.

Mr. Carty: --Justice--

Justice Scalia: I mean, just... just don't... maybe you think that that's what it ought to be, but... but please don't tell us that that is how it originated.

It plainly did not originate that way.

Mr. Carty: --Justice Scalia, I respectfully disagree.

It is true, as the commissioner and you point out, that at the time of the agreement between the husband and wife, the income tax was not in existence.

However, the agreement certainly was in existence after the income tax was passed.

So that could have been a reason why the agreement was never rescinded.

In addition, in another landmark case from 1937, Blair, this Court expressly looked to whether there was a tax avoidance motive.

And this is how this principle is taught in first-year tax class.

That's the whole purpose behind this.

As a matter of fact, the commissioner in a... in a different context actually looked to the fact, with respect to a particular transaction, whether there was as tax avoidance purpose.

Justice Scalia: That's a different argument.

I'm... I'm just quarreling over whether it originated that way.

If you want to say--

Justice Kennedy: Under... under your view--

Justice Scalia: --that's fine.

Justice Kennedy: --suppose that the attorney is... is waiting for payment of... of his, say, one-third contingency, and the client just absconds with the money.

How is... what... what happens from a tax standpoint under your theory?

I take it the attorney has to declare the income on his return and then declare a loss?

Mr. Carty: Well, certainly the attorney has a legal right to those funds.

He has a contractual right and under most--

Justice Kennedy: I'm asking you about the tax consequences.

Mr. Carty: --Well, at... at that point the income wouldn't have inured to the benefit of the attorney.

Justice Kennedy: Well, but I... I thought under your view the moment the client gets the check for the full amount, one-third of it is taxable to the attorney.

And I have some problems, incidentally, with respect to tax years if it... if you... if the client receives the check December 30 and is on vacation and doesn't get around to remitting to the attorney until January 5th, I'm... I'm not quite sure how your theory works, but--

Mr. Carty: Justice Kennedy, I... I think the--

Justice Kennedy: --But on the absconding theory, how... how is it handled from a tax standpoint?

Mr. Carty: --I believe that for tax purposes the attorney's right to the funds... that's at the moment he receives it.

So if he doesn't have the funds in hand, he wouldn't be liable for Federal tax.

It would be at the point he either receives the funds--

Justice Souter: Aren't... aren't you--

Justice Ginsburg: This is an academic question because he would have an offsetting theft loss.

Mr. Carty: --I... I think that is an alternative way to... to view it.

There would be a--

Justice Souter: --If... if you view it as the theft loss, you... you maintain your theory.

If you argue, as you were arguing a second ago, I think what, in fact, you're doing is adopting the mere lien theory.

Mr. Carty: --Justice Souter, I... I--

Justice Souter: I think you better go with Justice Ginsburg.

[Laughter]

Justice Breyer: Like somebody stealing a check out of my mailbox from my employer.

Right?

Okay.

Mr. Carty: --Yes.

Justice Breyer: So what is your theory, I mean, precisely?

A, an assignment of income, what would otherwise count of A giving an assignment of income to B, and therefore still be A's income because the asset remains with A, the work, or whatever.

Now, your theory is but not in the case that.

Now fill in the blank for me.

Mr. Carty: Justice--

Justice Breyer: Precisely, please.

Mr. Carty: --It would not be in the case that the funds are not under the control of the attorney.

Justice Breyer: Not in the case... it is an assignment of income to B, but not in the case where the funds are not in... when B... when B get... when B, the attorney, gets the funds, he controls them.

What's... what do you mean?

I don't get it.

Mr. Carty: I thought your hypothetical--

Justice Breyer: I want to know.

You have three... your problem on your side for me is that maybe all the equities are there, but I'd like to know the proposition of law that you want us to write in this opinion.

And now we had three theories, and one, the one that you seem to be adopting, is this exception to the assignment of income doctrine.

If that is what you're adopting, I'd like to know the precise form of words that create the exception.

If that's not the theory you're adopting, I would like to know what the theory you're adopting is.

Mr. Carty: --I would state, Your Honor, that the assignment of income doctrine simply does not apply when the... the client has no control or power of disposition over the income that was subject to the assignment.

There are at least five reasons why this type of contract--

Justice Breyer: He did have control.

He could have settled the lawsuit or not settled the lawsuit.

He controlled when the income was generated, and moreover, he could have stopped it from being generated by settling the suit or dismissing it.

Moreover, if he had not entered into this assignment of income, it would have been paid right into his bank account at the end.

It sounds an awful lot like the Lucases or like the Horsts or whoever, Old Colony Trust.

It sounds an awful lot like those cases.

Mr. Carty: --Justice Breyer, I... I think it's helpful to make a conceptual distinction between the claim, the underlying litigation claim, and the right to receive the funds.

Now, certainly Mr. Banks in this case had a right to enter into settlement or not.

He had a right to fire his attorney.

But once he assigned the contingent fee portion of the recovery, he, as a practical matter, had no ability, he had no control over that portion of the recovery.

Another fundamental difference between--

Justice Kennedy: That... that would be the same with the theater agent or the commission agent.

Mr. Carty: --We submit, Justice Kennedy, that the nature of the attorney-client relationship is fundamentally different from the types of relationships you cited, and that's because an attorney here is the one who's earning the income.

It's the attorney who is making the critical decisions.

Justice Kennedy: Well, you could say the same thing for the talent scout.

Mr. Carty: I would respectfully disagree.

I... I think there's a... there's a fundamental difference.

Presumably a... a actor or an entertainer... their... their market value is... already has some type of tangible value.

The... the agent might--

Justice Kennedy: Your client, in effect, earned the money by having this... undergo this... this discrimination.

That... that's--

Mr. Carty: --Well, Your Honor--

Justice Kennedy: --This is not the plumber hypothetical, which is I think quite misleading.

No.

No, I don't think that even the Government will defend that.

Mr. Carty: --Again, Your Honor, I think with respect to an entertainer, an entertainer necessarily doesn't need an agent.

Neither does an athlete.

Justice Ginsburg: Take an investment advisor and the client is not at all... doesn't know anything about the market, and he's got this whiz-bang advisor who makes millions for him that he never could have made on his own.

Mr. Carty: I... I think that might be more similar to the attorney-client relationship.

But Mr. Banks, unlike the athlete or unlike the entertainer, had no... no ability to... to recover these funds himself.

He essentially had two options.

He could have either done nothing and collected nothing--

Justice Breyer: Your... your... you want to fill in the blank, in other words, and say where the assignment of income is such, such that B was in effect the person who really earned the income, unlike Mrs. Lucas'... Mr. Lucas' or maybe Mr. Earl... I don't know--

Mr. Carty: --That's correct.

Justice Breyer: --husband... the wife didn't earn the income.

Mr. Carty: Right.

Justice Breyer: The husband did.

So you want to say where the... and then your answer, I guess... don't say I'm right if I'm not right, please, because I'll just find out later.

[Laughter]

The... the answer to the hypothetical about the agent and so forth is, well, so be it.

If a person wants to go to the trouble of carving out some of his income and assigning that over to the agent, let him.

Except for perhaps provisions of the code which we cannot now envisage... I can't because I'm not an expert... it doesn't matter since, after all, it would be deductible anyway.

Is that... is that what you're saying?

Mr. Carty: Well, Your Honor--

Justice Breyer: Tell me if I'm wrong, please, on this.

Mr. Carty: --Again, I... what we're saying is the unique situation of an attorney and a client, it is the attorney who's taking the laboring, or unlike the entertainer example where the... where... or the athlete example--

Justice Breyer: Okay, I see. You say double.

Both the income is earned by the attorney, and at that stage the client does virtually nothing.

So it's the reverse of the Earls or the Lucases where the husband was doing the work and the wife is getting the income.

It would be as if the wife was doing all the work and the husband just sat there and clipped coupons or whatever.

Mr. Carty: --That's correct, Your Honor, and in Lucas v. Earl, it was the assignor who earned the income that was subject to disposition.

Here--

Justice Ginsburg: I'm not so sure about that because why doesn't the theory that... that applies to the lawyer equally apply to the wife?

I mean, she took care of everything going on at home, and that enabled him to go out there and make all that money.

So without her services, just like without the lawyer's services--

Mr. Carty: --That is an excellent point, Your Honor.

Justice Scalia: You should agree with that.

You should--

[Laughter]

Justice Breyer: Those were less enlightened times.

Mr. Carty: Nevertheless... nevertheless, I... I think there may be some... some difference in degree that you might even recognize between the two cases.

Another issue I'd like to address is the impact of the fee shifting statutes, if I could get to that quickly.

It is a bedrock principle of taxation that settlements of a claim are taxed the same as a judgment would have been taxed.

Mr. Banks' settlement was achieved in lieu of his claims under title VII and 42 U.S.C., sections 1981 and 1983.

Now, each of these statutes contains a fee shifting provision which enables a court to award attorney's fees to a prevailing plaintiff.

The defendant in Mr. Banks' case, the California Department of Education... they therefore settled Mr. Banks' claim in lieu of their exposure under these fee shifting statutes.

An award pursuant to these fee shifting statutes is separate and distinct from a damages recovery and therefore should not be taxable to a plaintiff.

And the Federal tax consequences to Mr. Banks, the litigant who settles, shouldn't be any different as well.

Otherwise, this Court would be discouraging settlement.

Therefore, a judicial anti-abuse rule should not be misused to undermine the statutory scheme devised by Congress to encourage civil rights litigants to bring meritorious claims and vindicate national policy.

Unless the Court has any further questions?

Justice Ginsburg: --The Government says on that branch of it, well, the fees... the lodestar fee, that's one thing.

A court awards it, but that's quite different from the one-third/one-half even contingent fee.

The court has control over the fee shifting, but we're not dealing with any court award here.

Mr. Carty: That's correct, Justice Ginsburg.

Mr. Banks settled his claims.

Yet, we are pressing the point that Mr. Banks shouldn't be treated any differently for tax purposes than a litigant who recovers pursuant to a fee shifting statute.

Otherwise, the Court would be discouraging settlement.

If there's any other questions.

Justice Stevens: Thank you, Mr. Carty.

Mr. Carty: Thank you.

Justice Stevens: Mr. Salmons, you have a little over 2 minutes.

Rebuttal of David B. Salmons

Mr. Salmons: Thank you, Your Honor.

It is clear that the only thing that respondents' attorneys earned under the fee agreements was the right to be paid a fee for their services.

In petitioner's view, those agreements don't even give rise to an assignment of income in the ordinary sense.

If you look at the text of the fee agreement in the Banaitis case... the Banks' fee agreement is not in the record... among other things, it makes clear that if there is a termination... and it provides lots of grounds on which the attorney-client relationship can be terminated... that the attorney will be paid a reasonable fee, calculated at the sum of $175 per hour.

That doesn't sound like an assignment of any income or even an assignment of the underlying cause of action.

Even if it did, it is clear that in every assignment of income case, the assignor loses control over that income that he assigned.

That doesn't stop the application of the proper tax principles, however.

The... the respondents in these cases suffered a legally cognizable injury.

They had a claim.

That claim entitled them to a recovery.

They retained services to pursued that claim.

If they had paid their lawyers on an hourly basis, those lawyers may have been just as necessary to the actual outcome of the case as their contingent fee attorneys.

Both the... an hourly fee attorney and a contingent fee attorney in both of the States at issue here... and in fact, in all States of which I'm aware... received precisely the same attorney's lien.

That lien makes clear that the relationship between attorney and client starts out as that between a master and an agent and then is converted through the fee agreement to that between a creditor and a debtor, and the lien secures the debt and ensures its payment.

When the proceeds from the litigation are paid to the attorney, it satisfies the respondent's debt and is therefore income to the attorney.

Under the separate and alternative ground of this Court's Old Colony decision, it goes far and beyond even the holding with regard to an assignment of income.

To address just a couple of questions that came up, I would point out that in the class action context, again, as I indicated, there are a number of differences.

And just to be a little more specific about some of them, generally speaking there's no unilateral right to settle a... a case by class members.

There's no unilateral right to dismiss the case, and there's no right to a determined fee.

Justice Stevens: Thank you, Mr. Salmons.

Mr. Salmons: Thank you.

Justice Stevens: The case is submitted.

Attribution:

The Oyez Project

Featured:

United States v. Galletti - Oral Argument

Fri, 09 Jan 2009 14:49:07 +0000

Case:

United States v. Galletti

Media File:

02-1389_20040112-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Kent L. Jones

Chief Justice Rehnquist: We'll hear argument now in No. 02-1389, the United States v. Abel Cosmo Galletti.

Mr. Jones.

Mr. Jones: Mr. Chief Justice, and may it please the Court:

Federal employment taxes owed by a partnership were assessed by the commissioner, and when the partnership failed to pay the taxes, the United States brought this action to recover the taxes against the individual partners who were derivatively liable under State law for all debts of the partnership, including its tax debts.

Justice Kennedy: Did the Government have to wait until the partnership failed to pay?

Could it have proceeded immediately against the partners under... under the governing State law?

Mr. Jones: You've addressed an... an unanswered question that isn't presented here, of course.

It's unanswered because Federal law--

Justice Scalia: It... it's not presented, depending on what you mean by derivative liability.

I... I always thought that derivative liability would be liability that doesn't attach unless and until the person primarily liable fails to... fails to pay up.

Mr. Jones: --And... and I agree with that, and... and the Uniform Partnership Act, which California has adopted, contains a provision that specifies that the creditor must exhaust his efforts to recover from the partnership before he can recover from the partners.

Justice Scalia: I see.

Mr. Jones: And... and so that's what makes it clear this indeed a derivative secondary liability.

Justice Scalia: You think maybe the United States may not be bound by that.

You... you don't want to... you don't want to concede that the United States is bound by that.

Mr. Jones: It's not so much I don't want to concede.

I don't feel that I'm able to concede that not because it is related to this case, but because of a... a structural intellectual problem about the extent to which whose law governs in that situation.

If it's a limitations provision, we know Federal law governs when the United States is bringing a claim that it acquires in its sovereign capacity.

Whether this would be regarded as a procedural restriction that the State substantive law didn't... now, whether you want to think this is substantive or procedural may affect the answer to the question... the hypothetical that you've raised.

Justice Kennedy: Well, can you tell me as a matter of practice if... if you know?

Suppose there's a partnership which is a little murky.

It's in the Cayman Islands and they're behind, but that one of the... the general partners is in California.

Can you just proceed against him, do you know?

Does the Revenue Service--

Mr. Jones: Well, there--

Justice Kennedy: --ever do that?

Mr. Jones: There... there is an... the uniform... in the case law, there's a discussion of situations where the partnership is known to be insolvent.

You're not required to do a senseless act.

You're not required to pursue and exhaust against the partnership when it's known to be insolvent.

So in that situation, you have exhausted because the partnership is insolvent.

Justice Kennedy: And I take it in that situation... you correct me if I'm wrong... but you can't just levy on the account if the tax has not been assessed against that partner individually, but you can commence some other sorts of proceedings which would allow a subsequent levy.

Or am I wrong, or is that clear?

Mr. Jones: --Well, you've brought me through... to a lot of levels of complexity, but I think the answer to the question is we... we don't dispute that you need to give a... a notice of assessment in order to collect administratively through liens and levies.

That's not relevant to this case because this is a judicial collection case.

Justice Kennedy: Of course.

Mr. Jones: But, nonetheless, there is case law that says that when you give notice to the partnership of its liability, that's sufficient as constructive notice to the partners to permit administrative collection through liens and levies.

Justice Ginsburg: Mr. Kent, if you're not right about that and you do have to have individual notice and demand to the partners, then there's a consequence other than liens and levies, isn't there, where you have whopping penalties and interest attached?

I thought if you don't give notice and demand within the 60-day period, then not only can't you impose liens, but that the interest and penalties stop running.

Mr. Jones: I'm... I'm familiar with the... the concept of interest doesn't run until notice of the assessment is made, but nonetheless again, notice to the partnership would be constructive to the partners.

Justice Ginsburg: But if you're wrong about that constructive notice, then you could still say, well, the statute has been extended 10 years because of the assessment.

However, one might conclude that the interest stops running and that you can't use administrative collection procedures.

Mr. Jones: Well, I... I don't mean to be... I don't mean to sound like I'm retreating from that issue.

I'm just... it's not presented here, and so I'm not really capable standing here--

Justice Ginsburg: Well, it would be to the extent on... if... if this thing is remanded with instructions that the assessment counts against all of them, that there would be the question remaining about the interest and penalties.

Mr. Jones: --That's... I don't... it is possible, and if the Court were to reverse and remand for further proceedings, it's possible that that issue would be raised.

Justice Ginsburg: Are you... are you saying that we should maybe flag it but not decide it?

Is it--

Mr. Jones: I don't... I don't know what your practice would be.

I would think your practice would be to decide the issue that's presented.

You could note other issues haven't been raised, but since those issues haven't been briefed here, we're not really in a position to advise you on their proper resolution.

Chief Justice Rehnquist: --Why don't you go ahead with the issues that are presented?

Mr. Jones: Okay.

Well, the point I was making was that the court ruled against us because they said that the partnership taxes had not been assessed directly against the partners.

But respondents now correctly concede that there is no requirement of Federal law that a derivative or secondary State law liability to pay a tax has to be assessed before it can be collected, and that concession is plainly correct in light of this Court's decision in 1933 in the Leighton case where the Court held that a derivative or secondary liability that arises under State law to pay a tax may be recovered... and I quote... without assessment of that liability.

And there are numerous cases that have applied that principle in... in related secondary and derivative liability contexts.

And as... as I've already indicated, those principles plainly apply here because under the Uniform Partnership Act, which applies in California, the liability of the partner is derivative for the... and secondary rather than principal, as I've discussed with Justice Scalia.

Not only is it clear from the legal structure of the UPA, but the official comments to the... of... to that act state that the liability of the partnership for partnership debts is principal and that the liability of partners is... is in the nature of a guarantor.

It's secondary.

It arises only when the partnership doesn't pay its own debts.

Federal law also makes clear that this is a liability that attaches directly to the partnership.

This is a Federal employment tax.

It applies to employers because, under California law, the... the partnership is a separate and distinct legal entity.

It is the employer.

It pays the wages.

Its payment of wages is what causes the taxes to be imposed.

Chief Justice Rehnquist: But you... you agree that it's the law of California that imposes the derivative liability on the partners?

Mr. Jones: That's the way the cases describe it.

From my... and that's the way this Court described it in... in Commissioner v. Stern.

Chief Justice Rehnquist: What more do you want?

Mr. Jones: Pardon me?

Chief Justice Rehnquist: I say what more do you want.

Mr. Jones: Well, I don't want more.

I'm just being finicky I guess, because to me we... the Court in Commissioner v. Stern said that these... historically these are substantive liabilities that Congress accepts from State law.

And therefore, the Court applies the substantive body of State rules in... in implementing that liability.

You could also think of this... and I'm not asking the Court to reconsider Commissioner v. Stern.

But you can... even in light of Commissioner v. Stern, you can think of this as Federal law borrowing State law for this remedial purpose, and Congress has sanctioned that by not altering the principles that have long existed on this.

The... but the... the point that this Court made in Leighton is that these principles that they apply come from State law and you don't a... actually respondents now admit there's no mechanism in Federal law to assist this... assess this sort of secondary derivative State law liability, and that's correct.

That's what the Court addressed in the Leighton case.

And the court of appeals in this case just misapplied those well-accepted principles.

Once the assessment of the partnership taxes was made, under section 6502 the United States has 10 years from the date of the assessment to bring any proceeding in court to collect the taxes.

And in the Updike case in 1930, the Court held that that 10 years applies not only to actions against the directly liable party but also to a person whose liability is derivative or secondary and arises from State law.

And the Court explained that the broad purpose and broad text of 6502 applies equally in both cases because in the Court's words, in a real sense the action against the derivatively liable party is a proceeding in court to collect the tax.

As the Court said in Updike, the aim in the one case, as in the other, is the same.

It's to collect the tax liability.

Now, in this Court respondents do not dispute that accepted understanding of 6502.

Instead, they raise here a new and, indeed, a radical claim that no court has adopted and that they did not raise prior to their merits brief in this Court.

What they argue now for the first time is that the Federal statute of limitations should not govern this derivative liability claim because since it stems from substantive State law, the State statute of limitations should govern it.

Now, since they didn't raise that claim at any time before their merits brief in this Court... and it is a statute of limitations which is an affirmative defense... they're... they've waived the claim as too rate to... too late to raise it.

But nonetheless, I think it is important to note that their claim is plainly inconsistent with this Court's decisions.

For example, in the Summerlin case, this Court held that whenever the United States acquires a claim acting in its governmental capacity, that claim of the United States is not subject to a State statute of limitations because of the sovereign rights... sovereign immunity of the United States.

And they applied that holding in Summerlin to a situation where what the United States obtained was a right to enforce a private note and private mortgage that the--

Justice Stevens: May I interrupt for this question?

You know, there are some State statutes of limitations that... or some States have limitations provisions that are either affirmative defenses or some are, in effect, conditions precedent to bringing an action.

If California had the latter form of action, how would you decide this case?

Mr. Jones: --I think that in... in Commissioner v. Bresson where the Ninth Circuit addressed that very point, they... they were... they wrote a very useful opinion that seems to me to be perfectly correct, that the... that if it is the passage of time after the United States acquires its right that causes the claim to expire, that that is what is barred by the Summerlin rationale because the sovereign rights of the United States can't be extinguished.

And so whether you think of it as extinguishing the claim or limiting the... the period of recovery, in either event what's instrumental is that the... the United States had the right at the time it obtained the claim and that the State law could not thereafter cut that right off.

Justice Breyer: Why not?

Why... why... suppose that you have a... a bank that guarantees a debt, and the debt is Smith's debt.

And the guarantee is to pay, including tax debts.

That's what it says.

It was a condition of the borrowing or some other thing.

Now, why wouldn't State law govern the period of time in respect to which any creditor, including the Government, has to assert a... a claim under that note, let's say, or under that particular written guarantee since the liability there is a creation of State law and the State would have the right to define its contours?

And after all, that guarantor is not the taxpayer.

The... the guarantor's liability arises solely out of the fact that he happens to have entered into a note with a guarantor who promised to pay.

Mr. Jones: So you're talking about a... a private contractual right--

Justice Breyer: Yes.

Say a private--

Mr. Jones: --that the United States somehow obtained rights under by--

Justice Breyer: --Yes.

Mr. Jones: --levying, for example--

Justice Breyer: Yes, yes.

Mr. Jones: --on the... on the right.

Justice Breyer: Yes, yes, and then I'm going to say why isn't this that.

Mr. Jones: That's... that's a... that's exactly frankly what happened in Summerlin--

Justice Breyer: Yes.

Mr. Jones: --except Summerlin involved a housing program instead of the Internal Revenue Code.

In Summerlin, the Government obtained a private note and enforced it, regardless of the State statute of limitations, and the Court's reasoning was that the... that the United States as sovereign cannot be subject to limitations imposed on the rights that it obtains.

Justice Breyer: So if I... if I enter into a promise with you and say in return for my lending, you know, whatever it is, I... I promise that I will pay your tax debts, but by the way, I don't want to pay any tax debt that isn't definite before January the 5th, 2004 or 2010.

I don't want to pay anything that arises--

Mr. Jones: It's a limit... if you're talking about a substantive limitation in the document itself, well, the United States takes its... stands in the shoes of the assignor in that situation, and we don't get a better substantive right... substantive right.

Justice Breyer: --Okay.

So it's a substantive procedural distinction.

Mr. Jones: Well, certainly that's the way the Court has looked at it, and I--

Justice Scalia: But you know, in... in other cases, let's say when the... when the Federal Government creates a Federal right without establishing a statute of limitations for that Federal right, State law does not govern, but Federal law looks to the... to the State statute of limitations as a matter of Federal law.

I don't know why it wouldn't be the same thing with respect to a... a Federal claim.

You mean there is no statute of limitations whatever on Federal claims?

Mr. Jones: --No.

Well, that's the second route that the Court has used to say the State's limitations don't control, and that is, when there's a Federal limitations period that applies to the claim, then the State provision doesn't control.

Justice Scalia: Of course.

Mr. Jones: And under... under Updike, what this Court concluded in Updike was that there is a Federal statute of limitations that applies to these proceedings in court to collect the taxes, which includes the derivative claim.

Justice Scalia: Well, that... that's fine.

But I'm talking about the more general proposition that... that you're... that you're defending or... or proposing that... that State law does not... never... never applies to a... to a Federal claim.

Mr. Jones: Well, it doesn't--

Justice Scalia: I mean, a claim by the United States.

Mr. Jones: --It doesn't--

Justice Scalia: I think it does.

Now, it may not apply of its own force.

Mr. Jones: --Exactly.

Justice Scalia: But it applies because of adoption by the United States.

Mr. Jones: If the... if the Court were to find it appropriate in a particular instance to adopt a State rule, that would not interfere with Summerlin, but that would... that would... I can't think of a case exactly like that.

There may well be some.

But most Federal claims--

Justice Scalia: I can't imagine our not doing it.

I can't imagine our saying that, you know--

Mr. Jones: --Most--

Justice Scalia: --the clock keeps ticking on Federal claims forever and ever.

Mr. Jones: --Most Federal claims come within some general statute of limitations, and this is certainly a situation like that.

Justice Ginsburg: Is it... is this question really academic in this case because you have not one but two Federal limitations, one, the regular 3-year period, then the extension by 10 years following an assessment?

Mr. Jones: Well, I think the Updike case makes this discussion somewhat hypothetical, and I understood Justice Scalia's question to be in that vein.

Justice Ginsburg: But here, what you're relying on are the Federal limitations period.

So you don't need to worry about suppose there had been no Federal limitations.

Mr. Jones: I... I don't need to worry about them, and I... but I'm only addressing them because respondents have raised them at this point in the case, and so I'm just discussing the two theories that this Court has applied in rejecting that kind of contention.

Chief Justice Rehnquist: You're saying it's doubly hypothetical because they can't raise the whole issue--

Mr. Jones: Yes.

Chief Justice Rehnquist: --at this point anyway.

Mr. Jones: Yes, sir.

Unknown Speaker: I thought their primary position, though, was that the partners are not secondarily liable, they're primarily liable, so that they are the taxpayer and they're entitled to assessment notice and demand.

Mr. Jones: That is now clearly their primary position, and for the reasons I've already described that position can't be reconciled with the Uniform Partnership Act or with... or with the Federal law that applies to these taxes.

Justice Kennedy: Can you... can you tell me in the case of a corporation, if the responsible officer does not withhold employment taxes, I... I take it... I thought I remembered that... that the responsible officer is personally liable.

Or am I wrong about that?

Mr. Jones: Yes.

There is a statute that authorizes an assessment of that liability against a responsible officer.

Justice Kennedy: Ah, but you have to assess it.

Mr. Jones: It... it authorizes the assessment.

That's... you know, it's interesting.

There are certain types--

Justice Kennedy: Can... can you proceed against the responsible officer without the assessment?

Mr. Jones: --If you have a claim based on State law or common law, and that's the reason we have a responsible officer statute is that this is a Federal claim.

There isn't... unlike in the partnership situation and in the ordinary transferee situation, there's not a backup State law action.

Justice Kennedy: Well, if... if in the case of corporate officers, there must be an assessment, then by analogy it would seem that it wouldn't be too much trouble for the IRS to assess the partners in your case.

Mr. Jones: Well, sometimes it is troublesome, but it's not required in any situation under our understanding of the existing law.

Justice Kennedy: I... I thought that it was required in the... in... in the corporate case.

You said it has to be assessed against the responsible officer.

Mr. Jones: Oh, I'm sorry.

I thought you were talking about the partnership then.

Yes.

I... the responsible officers... officer liability is created by Federal statute, unlike the partners' obligation for the debts of the partnership.

Justice Kennedy: I'm simply wondering if... if that isn't a model, if that's what happens in the corporate instance, in this case where the statute is... is silent on the point, whether we shouldn't just assume that since it's not too much of a burden on the Government in the corporate context to require it to assess the responsible officer before the tax can be collected, that we shouldn't say the same thing here.

Mr. Jones: There is--

Justice Kennedy: I'm just--

Mr. Jones: --I understand.

But the responsible officer liability is... is really a radically different concept.

It only... it only arises when that officer had knowledge of the fact that the taxes weren't being paid as they accrued and willfully failed to pay them and... and was responsible, had the responsibility to pay them.

It is a... it is a malfeasance claim, whereas the derivative liability claim is just under State law, you are liable as is the partnership, and we can enforce that State law.

There's another example--

Justice Kennedy: --There's a--

Mr. Jones: --where the similar thing happened.

3505, which is the lender's liability.

There was no lender's liability for employment taxes that the Court discussed in the Jersey Shore case.

That liability didn't have a... a common law precedent, and so Congress created the liability because they saw a specific problem where lenders were allowing or in... in effect, helping employers evade employment taxes by loaning them money from which they paid wages but didn't pay taxes.

And so Congress created this separate statutory scheme.

But respondents are correct in their concession that there is no mechanism under Federal law for assessing the derivative State law liability of a partner for the debts of the partnership.

And so as the Court held in... in Leighton, we can proceed without assessment against them to enforce that liability.

Now, I do want to also mention the... the citations that respondents make to section 6303.

That section appears in the portion of the code that addresses administrative collection through liens and levies, and it states that the Secretary is to give notice of the assessment to any person liable for the tax.

The cases that have interpreted and applied that statute, which stem from 1954, have... have concluded correctly that that statute applies only to administrative collection through liens and levies and has no application to judicial collection actions.

And there's a... a sound historical explanation for that, and that is that prior to 1954, there were two independent routes for collecting taxes.

The Secretary was authorized by the code to bring a judicial collection suit, but there was a separate officer known as the collector of revenue for each district.

And the collector of revenue was, by the code, authorized to do the administrative collection through liens and levies.

And the predecessor of 6303 had said that the collector is to give notice of the assessment and make demands for payment.

And it was well established that that applied to his actions in administrative collection and had no application of the Secretary's independent authority to bring a judicial collection suit.

In 1954 in revising the code, Congress eliminated references to the collector in the code, placed the Secretary in charge both of the... of judicial and administrative enforcement and changed the predecessor language of 6303 from saying the collector is to give notice to saying the Secretary is to give notice.

But in doing so, Congress did not mean to change... and the courts that have reviewed this have correctly concluded did not change... the fact that this notice of assessment requirement applies only to the administrative collection area, has no application to judicial collection suits like this one.

Justice Ginsburg: --Are you conceding then that there could be no liens and levies against the partners here because there was no notice and demand--

Mr. Jones: I--

Justice Ginsburg: --individually to them?

Mr. Jones: --I don't think the record discusses whether there was notice to the partnership.

Justice Ginsburg: No, no.

To the partners.

Mr. Jones: No.

Justice Ginsburg: You just explained these two different routes.

Mr. Jones: Yes.

Justice Ginsburg: And you said that this is a judicial collection proceeding.

Mr. Jones: Yes.

Justice Ginsburg: So the other doesn't apply.

So I'm asking you if you are now making the concession that those words... what are they... each person liable for unpaid tax, would stop you from using the administrative collection route because you didn't give notice and demand individually.

Mr. Jones: Let me... I can't say what we did or didn't do in notice because there's nothing in the record on that in this case because administrative collection isn't involved in this case.

Justice Ginsburg: Well, let's assume you gave notice and demand only to the partnership.

Mr. Jones: Okay, let's assume that.

If we gave notice and demand to the partnership, what we would be authorized to do is clearly under 6321 and... make a lien and levy against any assets of the partnership.

And then as I said, although... the... the cases are also perfectly consistent that the notice to the partnership is valid as constructive notice to the partners.

And so, for example, if we have a partnership employment tax liability from Smith Construction and the two partners are Bob Jones and Bill Wilson, notice of the assessment to the partnership is valid as notice to its two partners.

And so our lien arises, if they don't pay the tax, but if a third party creditor is out there, First National Bank, the First... our notice to the partnership may not be notice to the First National Bank.

And so in a lien contest we might not have the prior lien vis-a-vis this other party, but vis-a-vis the two partners, the cases say that our notice is valid for 6303 purposes to them because, well, of course, a partnership only acts through its partners and notice to one of them or to the partnership is valid, constructive notice to all the others.

There is no case inconsistent with that conclusion, but again, it's plainly not presented in this case and we would not ask the Court to address it.

There's no need for it to.

This is just a judicial collection case.

The only issue that is really before the Court is whether we have to give notice... I'm sorry... whether we have to assess the individual partners to collect the State law derivative liability.

And for the reasons I've described, that the decision below is incorrect on that and... and should be reversed.

And I would like to reserve the balance of my time.

Argument of David R. Haberbush

Chief Justice Rehnquist: Very well, Mr. Jones.

Mr. Haberbush.

Mr. Haberbush: Mr. Chief Justice, and may it please the Court:

We've heard some interesting arguments, and I'd like to address the history here of the way in which this alleged derivative liability is imposed upon the partners.

We contend that the partners--

Chief Justice Rehnquist: Now, the Government says you... you did not raise what is now your principal argument until your merits brief.

Do you agree with that statement?

Mr. Haberbush: --Your Honor, no, I don't.

This case has always been about statutes of limitation.

We were addressing, in fact, a argument raised in the merits brief by the Government.

If the Court will note, at page 5... I'm sorry... page 12, footnote 5, this specific question is addressed by the Government stating that it's a Federal not a State statute of limitation that comes into play.

And our portion of the brief is simply a reply to that.

Justice Scalia: Wait.

It seems to me it's... it's... the burden is on you to make the claim that a State statute applies, and you never claimed that any State statute applies.

Now, the Government here, out of an excess of caution or maybe to explain the whole situation to us, puts in that footnote, but that doesn't create a claim on your part that the State statute governs.

Did you ever assert that... that this matter was governed by... by a State statute of limitations until your merits brief?

Mr. Haberbush: Yes, we did in the courts below and our briefs below.

Justice Scalia: You asserted that it was governed by a State statute of limitations.

Mr. Haberbush: Your Honor, what we argued was that if the Federal statutes did not apply, section 6303 requiring notice and demand, if these partners are not taxpayers under the Internal Revenue Code, then State law would govern.

And yes, we did raise it below.

Chief Justice Rehnquist: Did the court of appeals touch on it?

Mr. Haberbush: The court of appeals did not need to touch upon it, because the court of appeals felt and decided that these partners are taxpayers under the Internal Revenue Code.

And that's the precise question I would like to address.

Justice Stevens: Did you raise the statute of limitations point in your pleadings in the district court?

Mr. Haberbush: In the United... this originated in the bankruptcy court, so the district court--

Justice Stevens: Well, I mean in the bankruptcy court.

Mr. Haberbush: --Your Honor, we did.

We raised it both in terms of the statute of limitations under section 6303 and under State law.

Justice Souter: Did you raise it as an affirmative defense under State law?

Mr. Haberbush: Well, we objected to the proof of claim which is akin to an answer, and yes--

Justice Souter: And one ground of your objection was under State law it's barred?

Mr. Haberbush: --Our objection was a fairly generic objection in all honesty--

Justice Scalia: So we're talking about did you ever say this claim is barred by... it... it is too late under this State statute of limitations, citing the State statute of limitations?

Mr. Haberbush: --Yes, we did.

Justice Scalia: Would you provide us with--

Justice Stevens: --Where can we find that in the record?

Justice Scalia: Where will we find that?

Mr. Haberbush: I believe you'll find that at the... the district court level after the bankruptcy court.

Justice Souter: Well, isn't the place to raise it in the bankruptcy court?

I mean, that's where your pleadings... that's where your responsive pleadings were filed.

Mr. Haberbush: If indeed it is an affirmative defense, yes.

Our objection to the claim was this was not an enforceable claim under law, State or Federal, and our reason for it was barred by the limitations periods.

Justice Ginsburg: As a Federal--

Justice Kennedy: --Under California practice, I assume statute of limitations is an affirmative defense?

Mr. Haberbush: Yes, Your... Your Honor, it is.

We, however, believe that this case does not be controlled by State law, but rather by Federal law.

A partner's liability for the debts of a partnership may arise under State law, and this Court has noted in the case of United States v. Kraft that State law defines the rights as between the parties, but the manner by which it may be collected, the tax itself or the claim, is governed by Federal law.

And that is really the heart of what our argument is.

There is no specific Internal Revenue Code provision that makes a partner liable for a partnership debt.

What the Government in this case does is it relies specifically upon historical cases that stem from old section 280, which is adopted as section 6901 of the Internal Revenue Code, whereby assessments may be made against transferees, donees, and fiduciaries, and the cases interpreting those statutes basically find that there is a derivative liability with a coterminous statute of limitations.

Justice Breyer: This would be an odd State law, wouldn't it?

Imagine that I guarantee a debt or suppose a partner is like a guarantor.

And suppose that the primary... person primary... primarily liable is in litigation with the debtor... the creditor, rather.

And because of delays and so forth, it takes about 15 years to resolve this litigation.

I've never heard of a guarantor who wouldn't become liable at the time the thing is final and that the... he just becomes... I mean, how does it work?

I would have thought a guarantor is liable for the debt the debtor owes.

How does the statute work, the State statute?

Mr. Haberbush: Your Honor, we believe the State statute is... is one that does not require exhaustion of remedies as against the partnership.

Justice Souter: It has nothing to do with exhaustion of remedies.

Justice Breyer: I'm... and I'm talking about States... the State insofar as it sees the partner as a guarantor of the liability that is created by a different entity, namely the partnership.

And I'm asking if under State law of California, wouldn't it be the case that if he's a guarantor and you get the statute of limitations on a matter to determine liability extended, that the guarantee also extends.

Mr. Haberbush: That would--

Justice Breyer: There's no State law that says you have to sue the guarantor before the liability that he's guaranteeing is determined.

Mr. Haberbush: --That is correct.

Justice Breyer: All right.

If that's correct, what are we arguing about?

Mr. Haberbush: What we're arguing about here is that this is not a suretyship or a secondary liability--

Justice Breyer: Yes, yes.

You're back to your question of whether under partnership law in fact this is a guarantor or the equivalent or a surety.

I understand that argument, but it sounds to me as if that argument is resolved against you, this statute of limitations argument is a serious red herring because it won't matter.

Mr. Haberbush: --Well, unless Federal law controls.

Justice Breyer: Right.

Mr. Haberbush: Unless these parties are taxpayers under Federal law, in which case--

Justice Breyer: No, no.

If the primary argument, which you want to argue, that they're taxpayers or that they are primarily liable, you win it or you lose it.

If you win it, you win.

If you lose it, your statute of limitations argument adds nothing.

Mr. Haberbush: --I think not.

Justice Breyer: That's my... that's what I'm thinking.

Mr. Haberbush: I think not.

I think we win, and let me explain why.

It has nothing to do with limitations periods.

It has nothing to do with State law governing guarantees.

It has to do with the way this Court is asked to define this particular claim in this particular case.

Is it a tax claim or is it a claim which is derived from the partnership liability?

In other words, is it a tax debt or is it a debt because they're liable for a debt of the partnership so that it loses its nature as a tax claim?

If that's the case, this is a bankruptcy case.

Tax claims in bankruptcy have priority over other claims under section 507(a) of title 11 of the United States Code.

Those claims too are not dischargeable if they're a tax claim under section 523 of title 11.

So if the Court determines this is nothing more than a guarantee pursuant to State law and not a tax claim, then this debt will be discharged in this bankruptcy case.

Justice Scalia: Do you have... have any cases for that, that a tax claim loses its character as a tax claim when relief is sought not against the person primarily liable but against somebody derivatively liable?

It seems to me it's still a tax claim.

Mr. Haberbush: No, Your Honor, we do not have authority for that.

However, if it is a tax--

Justice Scalia: I wouldn't expect you to find any.

Mr. Haberbush: --However, if they are liable for the tax, this Court has already stated on a number of occasions, including the most recent case of U.S. v. Kraft, someone who is subject to the tax is someone who pays it, someone who is liable for it.

These parties are liable for the tax.

They are subject to the tax under section 7701(a)(14) of the Internal Revenue Code, and therefore they are taxpayers.

Once they are taxpayers, that invokes the provisions of section 6501 requiring assessment or suit within 3 years.

We don't claim that assessment is the only method.

We claim assessment or suit, which is consistent with the history of the cases, and that's a 3-year limitation period as to these--

Justice Souter: No, but you say that they're taxpayers because they're partners, and therefore they... and... and that's why the... their... their right to an assessment can be claimed.

But by the same reasoning that you follow, if they are taxpayers because they are partners, why isn't notice to the partnership notice to the partners or assessment against the partnership assessment against the partners?

Why... why do you, in effect, make a metaphysical distinction in the latter case but not in the former?

Mr. Haberbush: --Well, Your Honor, I don't think that we do.

I think that the argument that there is constructive notice merely because one is a partner creates notice to... notice to the partnership is notice to the partners.

There is no controlling case on this idea, and that would be too a question I think of State law, whether notice to a partnership is notice to the partners.

And we've clearly cited to California law that says you must commence a separate suit against the partner in order to obtain a judgment against it.

There is no California law that says that by filing a suit against the partner, that's sufficient for due process purposes of creating notice to the partners such that--

Chief Justice Rehnquist: We don't ordinarily decide questions of State law here.

I think we would generally feel perhaps the Ninth Circuit knows more about California law than we do.

Mr. Haberbush: --Well, certainly that's true.

And that's--

Chief Justice Rehnquist: I said, we would think.

[Laughter]

Mr. Haberbush: --Well, thank you.

And... and yes, this Court ordinarily does not address questions of State law.

We think that this is a Federal statutory interpretation.

Either these persons are taxpayers liable for a tax or they are not taxpayers liable some... for something that is not a tax.

Justice Breyer: The last part.

They are for... they are not taxpayers in the meaning of the statute who are liable for something that is a tax.

And I don't know why that wouldn't be.

Mr. Haberbush: Well, Your Honor--

Justice Breyer: And State law makes them, in effect, guarantors of debts.

This is a tax debt.

So they're guarantors of the tax debt.

So, therefore, they're liable for the tax or sureties or some other equivalent word.

Mr. Haberbush: --All of the cases referred to for the coterminous statute of limitations, which is what would be suggested would be applied here if in fact they are liable for this tax debt and therefore the provisions of the Internal Revenue Code apply, are all cases where specific enabling provisions created the liability of those persons.

Under section 6324, certain persons are made personally liable.

Under section 6901, certain persons may be assessed with taxes as transferees.

And those specific statutes have provisions in them that say that the assessment and collection and enforcement of the tax... this is 6901 and its predecessor, section 280, where the collection assessment and enforcement of the tax is subject to the same provisions and the same limitations as the tax itself.

So it's not surprising that you have cases like Leighton and Updike where the statute of limitations set forth in what is now 6502 applies to them because they're subject to the same limitation periods.

There is nothing in the Internal Revenue Code that sets forth a limitation period as to partners.

If one adopts the guarantor analogy, then this is conceivable a case where any number of years could pass where the partners would become liable.

Your... I would point out the Court's record in the joint appendix.

At pages 100 and 102, we have the proofs of claim that were filed in these bankruptcy cases, and these proofs of claim on their face show that the Government in this case is not simply filing a claim as though it were a lawsuit against these partners.

These proofs of claim were filed as secured claims in both of the two cases that are before the Court.

Secured by what?

Motor vehicles and real estate.

So the Internal Revenue Service is taking the position clearly, unequivocally that it can enforce this debt by the summary collection process which has been called awesome and... and super powers that are not available otherwise.

Justice Ginsburg: Whether they could or not, they're saying that the question here is a judicial action.

Mr. Haberbush: Well--

Justice Ginsburg: And... and so maybe they're wrong and maybe they're right about that, but that's not before the Court.

Mr. Haberbush: --That's not... that may not be before the Court, but the Government has taken the position the only way, the sole and single way, it can collect taxes is to file suits against partners.

We would suggest that if the Court were to permit assessment, rule that they are taxpayers subject to assessment, subject to suit, that that would enhance collection.

It would encourage partners at the earliest opportunity to cause their partnerships to pay taxes.

It would cause partners at the earliest opportunity to pay the taxes.

In this instance, you have proofs of claim--

Justice Souter: It... it would also cause an enormous number of assessments to be made that ultimately would have no... no use.

I mean, the... the amount of administrative assessing going on would... would be staggering.

Mr. Haberbush: --Well, the amount of suits could be staggering as well to collect these kinds of taxes.

Justice Breyer: What is the problem?

Suppose... I'm... I'm failing to see it but maybe... suppose it's true that what the Uniform Partnership Act says is true.

Partners are, quote, in the nature of guarantors, end quote, rather than principal debtors on the debts of the partnership.

So let's suppose they're like guarantors.

I would have thought that State law was something along the lines of a guarantor must be sued in order to collect a... a guaranteed debt within a period of time after it becomes determined that such a debt exists.

Now, I would think that that's how the normal State law runs.

So unless there's something Federal to the contrary... and by the way, if there is, they have 10 more years.

But unless there is something Federal to the contrary, there's no problem with bringing this case.

So the only question in this case is are they in the nature of guarantors.

And I'd be interested... well, A, I'm interested in your comment on what I just said, and I'm also interested in the comment of why they're not guarantors.

Mr. Haberbush: Very well.

Here the Internal Revenue Service has filed proofs of claim in the bankruptcy court not for the debt of the tax but for the tax, for the penalties, and for the interest.

Guarantors under California law are liable for the debt and perhaps the interest, but not for the penalties.

The Court will note that these proofs of claim are approximately three to four times as much as the amount of tax that was originally assessed against the partnership in the initial instance.

There is nothing in the record to suggest that these partners had knowledge or notice of these taxes at any time before these proofs of claim were filed.

Now, under California law, if you have a guarantor, the guarantor knows of the liability that that guarantor is offering surety for.

That guarantor knows that that liability exists.

That guarantor can encourage the principal party to pay the tax or the debt in question.

Here the policies that are urged by the Government do not encourage collection of this--

Chief Justice Rehnquist: Mr. Haberbush, do you defend the decision of the Ninth Circuit in this case?

Mr. Haberbush: --Yes, we do.

Chief Justice Rehnquist: That in order to collect against the partners, an assessment would have to be made against them?

Mr. Haberbush: No, not within that specific limitation.

We think that an assessment or a suit should be brought within the statutory period--

Chief Justice Rehnquist: Well, I thought... I thought the reasoning of the Ninth Circuit was that you couldn't collect against the partners unless you assess them too.

Mr. Haberbush: --To that extent, the opinion is wrong for the reason that it is a well-held proposition that suit or assessment may be brought under section 6501 within the 3-year period, so that it's not exclusively assessment that's involved.

And this Court and other courts, I believe, have... have ruled that assessment is not a prerequisite to collection.

However, some action must be taken within the statutory limitations periods.

Unknown Speaker: And the filing of a claim in a bankruptcy court is insufficient because?

Mr. Haberbush: It's untimely.

It is not done within the period of time--

Unknown Speaker: So this is simply a statute of limitations case.

Mr. Haberbush: --That's our position.

Yes, Your Honor.

It is simply a statute of limitations case.

The Government has contended that this is a tax governed by the Internal Revenue Code.

The liability may be created by State law, and this Court has consistently said while liability may be... be created by State law, the enforceability of that liability is a subject of Federal law.

The Federal laws provide for 6303 notice and demand.

They provide for... 6501 provides that assessment must be made.

The... the Government suggests that there can--

Justice O'Connor: Mr. Haberbush, would you be able, after the argument, to furnish the Court with the places in the record available to us where it shows that you raised the State statute of limitations issue below?

Mr. Haberbush: --Yes, I can.

Unknown Speaker: Thank you.

Mr. Haberbush: Yes, I can.

Justice Ginsburg: Why shouldn't an assessment against the partnership be good as to the partners as well?

I mean, the whole difference is that you'd have to add the... the names of the individual partners.

I mean, the assessment itself is something in a file in some building.

Right?

Mr. Haberbush: Well, the assessment is the notation or recording of the liability.

However, section 6203 says that to be a proper assessment, it must record the liability of the taxpayer and we, of course, say that the taxpayer also includes the partners.

And yes, there could be a single assessment naming numerous parties.

There are examples of that.

For example, a husband and wife are jointly assessed.

An assessment against a husband or a wife independently is not an assessment against the other.

So there are multiple assessments that are capable of being made under the code.

There are numerous other instances where assessments are made.

6901, for example, assessment--

Justice Ginsburg: Is it... does it... would it matter if in fact the partners knew... had received the... I assume that the notice and demand would come to the partnership.

This is a small partnership.

There were what?

Four partners involved?

If they had actual notice, would that make any difference?

Mr. Haberbush: --Your Honor, that might make a difference.

We... we would contend that it does not make a difference.

We have cited to cases... and I don't recall them right off the top of my... my head at this moment... where the assessment... in fact, that was Cool Fuel, Inc. out of the Ninth Circuit where the assessment actually has to be received and made.

It has to name who the taxpayer is.

Marvel v. the United States.

While the taxpayer there was named as a partnership's name, the individuals' Social Security numbers, taxpayer identification numbers, were on that... that assessment, and that was found to be good as to those persons even though they were not individually named.

Justice Ginsburg: But certainly they had actual notice.

Your big due process objection that you make would not... would... would be very thin, would it not?

Mr. Haberbush: I don't disagree with that, Your Honor.

There is nothing in the record below where there is... that issue has been addressed.

There is no facts that were derived at the trial of this matter where that was addressed.

There is nothing in the record--

Justice Ginsburg: But you addressed it in your brief.

You said if they didn't get individual notice and demand, that would be a violation of due process.

Mr. Haberbush: --Yes.

It is not before the Court, however, whether they did or didn't, and there's nothing in the record suggesting that they did get such notice.

That's why the... the Government relies so heavily on its constructive notice theory, although starkly absent from that argument is any California law to support that idea that notice to a partnership is constructive notice to its partners.

Turning back to the... the idea of the... the assessment in this case, the... there are striking examples throughout the brief of the Government, although the Government contends that it is not able legally to assess partners, there are no less than 12 cases cited in the briefs, 10 of which were cited by the Government, in which summary collection process was instituted against partners, and in... in any of those cases there was an assessment.

In fact, the one case that's cited by the Government, the... the United States v. Wright... that's the case which came out of the Seventh Circuit that the Government contends is in direct conflict with the Ninth Circuit case in this instance is one where the United States District Court in its findings found that the partners were assessed.

And it's not surprising therefore, that the Wright court found that there were--

Justice Ginsburg: It said that... but I thought Judge Easterbrook said that that was irrelevant, that there might have been a fact question about that whether there were individual assessments.

But in any case, the court's rationale had nothing to do with that.

Mr. Haberbush: --That is correct.

However, the district court did find that there were assessments.

The Seventh Circuit found that that was irrelevant to the... the determination.

However, it is entirely consistent with the idea that in that case there were coterminous statute of limitations.

For the reason that assessments were made within the statutory period of time... that was still within the coterminous periods... then the collection.

The question was whether the 6502 allowed the collection against the partners who were jointly liable with the partnership in that instance.

The statutory period of time allowed to the partnership, because it had been tolled during a bankruptcy, the court found coterminous statute of limitations, relying on the Updike case as its example.

We... we believe that the collection of taxes would be enhanced by adopting the position that we have taken in this case.

We believe that requiring the filing of lawsuits in every instance where partners are liable for the debts of a partnership which has failed to pay its taxes and which may or may not be out of business, is simply a policy which would have litigation that is not required.

If the partnership is liable for the tax and this Court were to find that the notice provisions of 6302 and the provisions of 6501 allowing suit or assessment within 3 years applies, that that would enhance the collection of taxes.

We believe that... excuse me... we believe that by doing that, the tax will be paid at the earliest possible time.

Interest and penalties, such as have accrued in this case, would not accrue because the partners would be encouraged at every point and at every spot to cause their partnership to pay or to pay the tax themselves.

The Government is not in the business of banking tax claims, if you will, allowing them to accrue penalties and interest and thereafter, for who knows how many years, potentially as many as 3 plus 10, and if suit is filed within the 10 years under 6502, the... the term for enforcing a judgment.

So it could be 20-25 years that a partner could be out there liable for the tax during which penalties and interest continue to accrue, and then finally one day maybe that partner or that partner's estate or the partner's beneficiaries of the partner's estate might become liable for this tax.

We believe that by filing the tax... by filing an assessment at the earliest possible opportunity against the partners, this would encourage tax collection.

Justice Ginsburg: Nothing would stop a partner from paying the tax.

Mr. Haberbush: If the partner knows, that is correct.

If the--

Justice Kennedy: Isn't it reasonable to assume most partners know what's happening in their business?

Mr. Haberbush: --I don't know that it's unreasonable to assume that, but I suppose it is reasonable.

However, there are partnerships and there are partnerships, and some partnerships have managing partners who are actively involved in the business of the partnership and--

Justice Kennedy: Yes, but I... I would think, by and large, most partners know what's going on.

I mean, certainly there are exceptional cases, but certainly that's not typical.

Mr. Haberbush: --Unfortunately, I'm only involved in my law partnership and I know what's going on there.

I've not been involved--

Justice Scalia: Maybe you shouldn't be a general partner if... if you're not prepared to know what's going on.

It's pretty risky.

I mean, that's... that's the responsibility you assume when he... it only applies to general partners.

It doesn't apply to limited partners.

Mr. Haberbush: --That's exactly right.

Justice Scalia: So don't become a general partner if you're not willing to know what's going on in the partnership.

I... I thought that's the deal.

Mr. Haberbush: Well, Your Honor, I don't know whether that--

Justice Scalia: That's what it means to be a general partner.

You're... you're going to be liable for what the partnership does.

So you better pay attention.

I... and you're saying this is unjust somehow?

Mr. Haberbush: --Well, yes, it is, Your Honor, for the reason that does that mean that every partner has to go through every single piece of mail that enters the partnership and be familiar with every single thing that occurs?

Justice Kennedy: No, but when you accumulate tax liabilities of several hundred thousand dollars, they ought to find that... be able to find that out.

Mr. Haberbush: Well, Your Honor, these are over a number of quarters.

These were not all assessed at one time.

Justice Kennedy: Which is all the more reason they should have known about it a lot earlier.

Mr. Haberbush: Well, husbands oftentimes hide things from their wives who are a joint taxpayer as well.

Justice Ginsburg: But we're talking about a partnership that has not paid... what was it... FICA and FUTA taxes.

Surely, the partners were aware that they were not paying the taxes that were due year after year.

Mr. Haberbush: There's nothing in the record that suggests--

Justice Scalia: Who was responding to these letters from the Government?

The secretary?

Mr. Haberbush: --Your Honor--

Justice Scalia: I mean, does she take it in to... to her boss who was presumably one of the general partners and say, hey, you know--

Mr. Haberbush: --If it's a--

Justice Scalia: --the Government says we owe a lot of money.

Mr. Haberbush: --If it's a managing... if it's a managing general partner, I assume that that's the case.

If in fact the partnership had ceased its operations and these notices came afterwards, who knows who received the notices.

I don't think that the law imposes a burden upon every single general partner to look at every single bill and piece of paper that comes into a partnership.

Justice Kennedy: No, but you shouldn't rely on the United States Government to tell you what you... how your financial affairs are coming along and be the primary source of information.

Mr. Haberbush: That may be so, but if the... if the Government were required to do so, partners would at every point in time be encouraged to cause the partnership to meet its financial obligations.

Justice Breyer: It doesn't place that kind of a burden on the partners that you're talking about.

They're entirely free not to read the mail.

Mr. Haberbush: Well, that's... that's correct.

Justice Breyer: But... but the problem is they're going to be liable for whatever debts are incurred by the partnership if they don't do it.

That's the only burden imposed.

Mr. Haberbush: Well, Your Honor, and looking at burdens there is no... there is no insignificant... excuse me.

It's not a significant burden to place upon the Government to simply send another notice to the partners regarding their derivative liability for these claims.

Justice Souter: And it's not a very significant burden to a partner to say you better make sure they're paying the taxes.

Mr. Haberbush: Well, of course.

However, there... there have been dishonest partners, and the cases that I cite--

Justice Souter: You better be careful who you form a partnership--

Mr. Haberbush: --Well, yes, and there are cases cited in the briefs that say exactly that.

However, if... if the policy is to collect taxes and collect them promptly, then that is encouraged, rather than filing suit against partners, by a simple assessment sent in the mail to the partners.

If there is nothing further--

Justice Stevens: --Does an assessment affect your credit rating?

Mr. Haberbush: --Yes, it does.

It does.

Justice Stevens: So... so you want... all right.

Chief Justice Rehnquist: Thank you, Mr. Haberbush.

Mr. Haberbush: Thank you.

Unknown Speaker: Mr. Jones, you have 5 minutes remaining.

Rebuttal of Kent L. Jones

Mr. Jones: Thank you.

At page 3 of respondents' brief on the merits, they say... and I quote... if respondents are secondarily liable for the partnership taxes, then the Ninth Circuit's ruling that the IRS must assess respondents to collect the partnership taxes is incorrect.

It is clear to us that there is... this is a secondary derivative liability that partners have under State law.

I didn't hear respondents give any explanation of why that isn't so.

Given those two facts, then this Court's holding in Leighton seems clearly applicable, which is that we don't have to assess a derivative State law liability to bring suit to recover upon that liability.

Now, respondents say, well, somehow that holding is influenced by the fact that transferee liability is provided in 6901 of the code.

It's interesting that in... in the Leighton case what the Court held was that the 6901 transferee liability is a supplementary remedy that did not displace and, indeed, left in place the right of the United States to bring its suit upon the derivative State law liability without assessment.

So the... the principle that we draw from the Leighton case is not dependent on any of the specific statutes that address specific types of... of assignments of transferees.

In fact, it's utterly independent of that, which was the very issue the Court decided in Leighton.

Given that and... and given that there's a derivative sub-secondary liability, we can recover against State law.

Then the only other question is, well, what statute of limitations applies to that, which the Court held in Updike that it's 6502 which applies both to the direct liability and the derivative liability.

Justice Breyer: See, that's what I'm really wondering about.

I mean... but... but I mean, A, they may have not have raised it below.

B, it's not within the scope of the question.

C, it may not make any difference because the State and Federal may give you enough time anyway.

But if you do have to get to it, I'm... I'm a little worried about it because I don't... I don't really see why it should be Federal.

Mr. Jones: The reason it should be Federal is because all of these actions are designed, as the Court stressed in Updike, to collect the tax.

We have different remedies.

Congress could Federalize all of this.

Congress could write a statute that said, you know, you can bring suits for derivative liabilities and that those suits will... specifically subject to 6502.

And what the Court noted in Stern was that Congress hasn't done that because the Court has consistently applied State law to permit such tax collection to occur.

And... and so that's why Updike has got to be right because this is a strong Federal interest in collecting taxes, not to be too big about it, but I mean, this Court has noted that the collection of taxes is the lifeblood of Government.

This is as sovereign a claim as we have, and... and because of that, we need to have a uniform statute of limitations, which Congress has provided under 6502.

If... if we were left to the haphazards of State law, we would certainly want Congress to... to address that and correct it, but they don't need to correct it because since 1930 in the Updike case, the Court has explained that 6502 is broad enough to cover both types of... of judicial collection proceedings.

In the Court's words, the action against derivatively liable party is in every real sense a proceeding in court to collect the tax, and that's the... that's the statutory language.

And... and I... there has been no contention that that's not a correct interpretation of 6502.

I do not know what references respondents may have in mind to arguments they raised under State statutes of limitations before.

We're not familiar with those.

The statute that's referred to in their merits brief is a specific State statute.

We're not aware that that statute was ever cited before by the parties in this case, but even if it was, it seems to us that the reasoning of the Summerlin case and... and of Updike, which is... there's already a Federal statute... should control that question and--

Justice Ginsburg: Mr. Jones, why isn't Mr. Haberbush right at least when he says everybody would be better off if you went ahead and listed the partners as well on the assessment and gave them notice and demand?

Then there would never be any hassle of whether you could use both remedies, administrative and judicial.

Mr. Jones: --I think it's a question for Congress what's... you know, what makes everybody better off.

And what Congress has said is that we can assess these taxes against the employer.

The employer under State law is a separate and distinct legal entity known as the partnership.

Justice Ginsburg: Do you think you're impeded that you have no authority to give the partners notice individually?

Mr. Jones: We... well, we have authority to give them notice of an assessment and collect from them administratively, but in terms of, if you will, making an assessment them directly, we're supposed to assess the party whose subject to the tax.

Chief Justice Rehnquist: Thank you, Mr. Jones.

The case is submitted.

Attribution:

The Oyez Project

Featured:

Boeing Co. v. United States - Oral Argument

Fri, 09 Jan 2009 14:50:37 +0000

Case:

Boeing Co. v. United States

Media File:

01-1209_20021209-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Kenneth S. Geller

Justice Stevens: We'll now hear argument in our first case, Number 1209, the Boeing Company against the United States.

Mr. Geller.

Mr. Geller: Thank you, Justice Stevens, and may it please the Court:

The Internal Revenue Code generally requires every corporation to pay an annual tax measured by its entire net income, but Congress decided 30 years ago in the DISC and FSC statutes that it wished to encourage exports by giving favorable tax treatment to the portion of a company's net income that's attributable to export sales.

In order to determine the extent of this income tax benefit, it's obviously critically important to determine precisely how much net income is generated by a company's export sales in any particular year.

In enacting the DISC statute, Congress said quite specifically how it expected this export net income calculation to be made.

Gross revenues from export sales were to be reduced only by those costs that were directly and factually related to the export income.

Export sales revenues were not to be burdened with unrelated expenses which would distort the true amount of export income, and thereby reduce the intended incentive.

The DISC regulations, which were promulgated shortly after the statute was passed, reiterate that there must be a direct factual relationship between export sales and expenses.

Justice Scalia: Where do you... do you get that proposition in the statute, Mr. Geller?

Mr. Geller: Justice Scalia, we get it out of two separate statutory provisions.

One is section 994.

Justice Scalia: Where are these to be found?

Mr. Geller: These are... this is found on page 27a of the appendix to the petition.

And specifically, the reference in 994(a) and 994(a)(2) to the requirement that a determination must be made of the net income, quote, attributable to export receipts.

We think that the common sense nature of the word attributable, which this Court in the tax context has construed to mean generated by, or caused by, is that you have to take the export... the revenues from exports and reduce them only by the costs or deductions that are related to those exports, or else you can't possibly come up with a true figure of export... net export income that's attributable to those... to those sales.

Justice Scalia: I... I suppose that... that R&D expenses have to be attributed in a lot of other instances under the code, don't they?

And... and doesn't the Government use this same procedure that it's been using here in other... in other areas where it has to attribute... where... where R&D expense has to be attributed?

Mr. Geller: Yes.

It relies on a provision, which we'll talk about in a few minutes, that has many, many applications, and it may well be that in a number of those other applications, it's perfectly valid.

Our position is--

Justice Scalia: Well, why is that?

I mean, why is it attributable--

Mr. Geller: --Well, as I hope to--

Justice Scalia: --okay elsewhere to... to produce this result, but not okay here to produce this result?

Mr. Geller: --Because it... the DISC provisions are unique in a number of respects, one of which it allows the taxpayer to engage in a particular grouping of transactions, and the... the... as we'll talk about in a few minutes, the R&D regulations insist that R&D be attributed in a way that disregards the particular groupings that the taxpayer has selected.

But there's another statutory provision that I'd like to call your attention to, Your Honor, and that's section 861.

861 is a section of the code that has been in the code, was in the code for more than 50 years at the time the DISC statute was passed, and it provides for how deductions are to be allocated to gross income.

This... this appears at page 26a of the appendix.

Now Congress, in passing the DISC statute, said quite specifically that it wanted deductions under the DISC statute to be allocated in a way generally in accordance with the principles of section 861, which were well-established at that time.

Justice Scalia: Where... where did Congress say that?

Mr. Geller: Congress said that in the reports of the House, of the tax-writing committee.

Justice Scalia: Just for my benefit, when it's in the statute, would you say Congress said it.

When it's in legislative history, would you tell me who said it?

Mr. Geller: Yes, Your Honor.

Justice Scalia: Because when you say Congress said it, I thought you mean it's in the statute.

Mr. Geller: Well, it's not in the statute.

It's in the reports of the tax-writing committees.

But, Your Honor, these were not idle statements.

These were not statements of individual Congressmen, or statements on the floor.

These were deliberate statements put in the reports of both the House and Senate tax-writing committees which focused specifically... specifically... on how Congress expected these deductions to be allocated.

And I would refer the Court to page--

Justice Scalia: And I'm sure everybody who voted for that knew about those statements.

Mr. Geller: --Your Honor, these were specific statements that went to the heart of the issue that's before the Court today, and we've quoted them at page 22 of our brief, the blue brief.

Congress said that these 861 rules--

Justice Scalia: The committee said.

Please, please.

Mr. Geller: --The committee reports said... excuse me, Justice Scalia.

The committee reports said that... that the 861 rules, which are important because later the regulations themselves under DISC reference the 861 rules, so it's... and that's the heart of the Government's argument in this case, so it's important to understand what people thought at the time these 861 rules meant.

Justice Kennedy: But... but why does 861 get you out of the general allocation provisions any more than 994 does?

In other words, the question was, why do we ignore the usual rule for apportionment of R&D?

And you said, well, because 994 is... is specific and... and has some policies of its own.

And then you said... and to further that argument, you show us 861.

Mr. Geller: Yes.

Justice Kennedy: But the regs that we're talking about, which the Government relies on, are under 861.

Mr. Geller: Yes, but the... the regulation, Justice Kennedy, that the Government relies on was added to 861 after the DISC regulations were finalized.

It was added in 1977.

The DISC statute was passed in 1971.

The DISC regulations were finalized in 1975.

So our position is it's important to understand what Congress in 1971 thought it was doing in the DISC statute, and therefore it seems to us extremely important that it said that it expected deductions, including presumably any deduction, including R&D, to be allocated in accordance generally with the principles of section 861, which were described quite clearly in the Senate and House reports of the tax-writing committees to--

Justice Ginsburg: Mr. Geller, there's one problem.

Perhaps you can cast some light on it.

The word is attributable that you pointed to in 994.

And the R&D you have divided into Blue Sky and program or product-specific.

Mr. Geller: --Yes.

Justice Ginsburg: That... that's Boeing's creation.

The R&D... that division is eminently manipulable, it seems to me, if it... it's the distinction between whether it's allocated across the board because of Blue Sky or particular program or project depends on some official act by a corporate board which could be yesterday, could be next month.

It's in the control of the corporation.

Mr. Geller: Not... not quite, Justice Ginsburg.

It's not manipulable.

It has to satisfy the regulations promulgated under DISC.

The DISC regulations... and here I would refer the Court to page 33a of the appendix to the petition, and specifically the grouping regulations... provide that a taxpayer can only group... can only group transactions if they fall within a recognized industry product line.

So, in other words, you can't... you can't allocate expenses to any sorts of transactions you want.

They have to be grouped in a way that's consistent with the DISC statute.

And that's exactly what Boeing did here.

The Blue Sky R&D was attributable to all of their airplane products, and therefore it was allocated to the groupings of all of the different airplane programs.

These program-specific R&D... and I don't think there's any factual dispute about this.

The program-specific R&D was factually and directly related only to a specific program.

The 747 R&D, for example, was... was factually and directly related only to the 747 program.

And that's why Boeing allocated that R&D only to the 747 program.

Justice Stevens: Mr. Geller, can I ask you a factual question that will help me understand?

Does the... is there just one DISC involved here, or do you have several DISCs for different product lines?

Mr. Geller: No.

It's one... it's one DISC.

Justice Stevens: So that what difference would it make whether it was the 747 program, or the 727 program if the DISC sells them both anyway?

Mr. Geller: Because, Justice Stevens, under the statute, combined taxable income or export income is... is to be determined on the basis of product groupings, or at least, the taxpayer has the option of choosing to group by different products rather than by all the sales of the DISC.

So, therefore, here, we determine what the export income is for the 747 program, which takes the revenues from the 747 program and reduces them by the deductions, including R&D that's factually and directly related to the 747 program, and you... you come up with the CTI for the 747 program.

Under... it's not all mixed together as one group of export income.

Under... under the statute and regulations Boeing was entitled to group transactions.

The... the problem here is that the regulation that the Government relies on takes huge amounts of R&D that are directly related to a specific program and allocates them among all of the programs.

Justice Stevens: But, of course, the converse, I suppose under your view, all of the R&D would go to the domestic corporation because it all takes place before the product is put on the market.

Mr. Geller: No.

It doesn't really matter whether the product is on the market or not, Your Honor.

It has to be allocated to a class of gross income.

Now, that class of gross income may well include, as it does in this case, products or programs that aren't yet on the market that are being developed.

Justice Stevens: Right.

Mr. Geller: And nonetheless, the regulations are quite clear that the deductions have to be allocated to that class of gross income.

So, for example, in the 757 program, which was in... which was being developed in 1982, there were no sales of the 757 in 1982, and yet there were hundreds of millions of dollars of R&D expended in that year.

In our view, the regulations make it quite clear that Boeing had to allocate those deductions, that R&D and other deductions, to the 757 program.

Justice Souter: Well, what... what do you say to at least this argument of the Government?

I... I guess the Government would probably say, sure, there's... there's a kind of factual sense in which there is the kind of relationship that you're talking about.

But if you want the closest relationship... the most perfect relationship... you would capitalize your R&D and you would start amortizing it when you actually have a product that is generating income that you're selling.

That would be the closest match you could get.

That match, in effect, has... has been... has been set aside.

Instead of forcing you to do that, the law now allows you to... to use your R&D as... as a current expense.

Once you start using it, once you start treating it as a current expense, that very close relationship that you have, if you had capitalized it, is gone.

And what the Government is saying is, it's a judgment call how close it's got to be now, now that you have broken the link and have allowed current expense.

And that kind of a judgment call is quintessentially the judgment call that the... that the Treasury makes when it's write... when it writes regulations.

And why isn't that a pretty powerful argument?

And if it is, how do you get over the point of reasonableness or... or Chevron deference as the Government would see it?

Mr. Geller: Well, Justice Souter, you've described the Government's position.

Let me see if I can respond to it.

But generally, just... as to the last point... this is not a legislative regulation.

There really is no Chevron deference that's in play here.

Justice Souter: Well, there's... there's... certainly there is some degree of deference here.

Mr. Geller: There is some degree of reasonableness.

Justice Souter: We can argue whether it's Chevron or not.

Justice Ginsburg: It was a notice and comment regulation.

Mr. Geller: It was, but it was promulgated under section 7805.

There's no specific provision in the code that allows the Treasury to issue legislative regs here, but I don't want to get off on that because it--

Justice Ginsburg: But you... if it's... whether you call it... if you call it an interpretive regulation--

Mr. Geller: --Yes.

Justice Ginsburg: --it still deserves some respect from a court--

Mr. Geller: Yes.

Justice Ginsburg: --does it not?

Mr. Geller: Yes, it does but it has to be consistent, obviously, with the legislative scheme that it's interpreting.

Justice Souter, let me answer your question a number of different ways.

First, it is not at all unique for expenses to give rise to future year income.

In fact, most expenses give rise to future year income.

The fact that an expense may occur in year 1, and the income may be generated in year 2, is a commonplace.

It doesn't in any way--

Justice Souter: Sure they do.

Mr. Geller: --It--

Justice Souter: But the most precise way to match it, I... I would suppose, is the capitalization way.

And the Government says once you... once you lose the quintessentially perfect way of doing it, then how you're going to recognize it is a judgment call.

Mr. Geller: --Well, I don't accept... they can't capitalize it, Your Honor, because Congress made a judgment in section 174 of the code in order to encourage R&D to allow it to be immediately deducted in the year in which it's incurred.

Justice Souter: Absolutely.

And they say when Congress made that judgment, there's a further judgment left and that is the judgment how close has it got to be.

Mr. Geller: Yes, but the Government's regulation here is not close at all.

The Government concedes that... that expenses for R&D give rise to future year income.

They can't... because of section 174, they can't--

Justice Souter: Well, sometimes... sometimes they do and sometimes they don't.

I mean, if things work out fine, the answer is yes.

If they don't work out fine, the answer is no.

And that's... that's one of the... that's one of the problems that the Government raises.

Mr. Geller: --Well, look at what the 8(e)(3) regulation does, Your Honor.

It doesn't make any attempt to match current year R&D expenses with some future income that might be generated from that R&D.

What it, instead, does, it allocates all of that income to current year expenses... to current year revenues for products that have no relation whatsoever to that R&D.

For example, let me say... come back again to the 757 program.

Justice Souter: Well, here... may... may I interrupt you with this question?

Mr. Geller: Sure.

Justice Souter: You say it has no relation whatsoever.

I take it then you are saying that the Government is simply factually wrong when it makes the statement that R&D, which may have a closer relation to one product line than another, nonetheless tends, as a general rule, to have benefits that go beyond product lines.

We... they... they, in effect, say, look, you learn useful things, and you use them all over the place.

Are you saying that that is factually wrong?

Mr. Geller: Yes.

I'm saying that... that... I'm saying clearly in this case it's factually wrong.

For example, this case went off on cross motions for summary judgment.

There was really no dispute that Boeing had... as a factual matter... allocated the R&D expenses correctly.

As a factual matter.

The Government said they had to be reallocated because of this conclusive presumption in section 8(e)(3).

But, yes, I'm telling you, Justice... Justice Souter, that that's incorrect as a factual matter, that in fact, under section 174, in order to take a deduction for R&D at all in any circumstance, DISC or no DISC, the taxpayer has to be able to factually relate that R&D expense to a particular product.

Justice Souter: Oh, you've got to show the relationship--

Mr. Geller: Yes, factual relationship.

Justice Souter: --but it doesn't follow from that that there is no benefit to product lines outside of that relationship.

Mr. Geller: Yes, but if there... there could well be a spill-over benefit to future product lines, but that doesn't, A, mean that it's not directly and factually related a specific current program.

And also, look at the oddity and anomaly of the Government's position here, Justice Souter.

Even if it is... there is some spill-over effect for future product lines, when the Government... when the... when Boeing was developing the 757, it's conceivable that they were learning things that would benefit future products.

But what the Government does is take all that R&D and allocate it to existing products, sales of existing products that couldn't possibly have benefitted from that R&D.

Justice Breyer: That's so.

But could... I'd like very much to hear your response to Justice Kennedy's question.

Was it... and where we started was with Justice Scalia and Justice Kennedy.

And as I understand where they were driving, there is a statute, and the statute is DISC.

And under this statute, there's either some language, or there's some history anyway, which is of interest to me, which says when you work out the allocation rules, follow section 881... or 861.

Mr. Geller: 861.

Justice Breyer: 861, which is for allocation of all kinds of things--

Mr. Geller: Well--

Justice Breyer: --for Puerto Rico, to abroad, et cetera.

So now we look to 861.

Mr. Geller: --But--

Justice Breyer: And lo and behold, what they did in 861, after DISC was passed, is they changed the 861 rules, and in those changed rules, it says you're going to allocate everything to a SIC category called transportation services.

And then it has a little sentence here.

The taxpayer may not subdivide the categories in this list.

Mr. Geller: --Yes.

Justice Breyer: All right?

So that's their 861 rule.

Mr. Geller: That's... that is the--

Justice Breyer: All right.

Now, what legally is wrong with that--

Mr. Geller: --What's legally--

Justice Breyer: --since Congress told them to use 861, and here they're using it.

Mr. Geller: --Well... well, there are a number of things wrong with that, Justice Breyer.

The first is, as you yourself pointed out.

At the time Congress made this cross-reference, at the time the legislative history said that the rules under 861 would be followed, and at the time the regs were issued in 1975 that cross-referenced 861, this 8(e)(3) rule, which is an aberrational rule, doesn't follow the general guidelines of the 861 rules.

It was not even in the regulation.

Justice Breyer: That's right.

In respect to that, for you to win on that, we'd have to say that Congress intended that the rules be different for DISC's than for Puerto Rico, for Europe, for Saudi Arabia--

Mr. Geller: Oh, absolutely.

Absolutely.

Justice Breyer: --for everything.

Or we'd have to say that we're throwing out this reg for everything.

Mr. Geller: No, no, no.

The reg has many other applications, and we're not suggesting that it be--

Justice Breyer: So you're saying DISC has to be different.

Mr. Geller: --I'm saying DISC is different, Justice Breyer.

Justice Breyer: Okay, what in--

Mr. Geller: And let me explain, if I could--

Justice Breyer: --Yes.

That's what I wanted to--

Mr. Geller: --why DISC is different.

Justice Breyer: --That's... we are.

I... all right.

Mr. Geller: DISC is different because... for two reasons.

One is, DISC provides preferential tax benefits to a... to a subclass of net income, export net income.

It is critically important to have an accurate calculation of what the export net income is.

You cannot have an accurate calculation of the net income from sales of 747s if you're going to start with the gross revenues from the sale of 747s, and then you're going to deduct from it expenses that have no factual relationship to 747s.

You inevitably are going to be left with an erroneous net income calculation.

Now, I want to also add that this was focused on in 1973 and 1975 when the Treasury was issuing its DISC regulations.

In 1973, Treasury issued proposed regulations under 861 that specifically said how R&D was going to be... was going to be allocated in the context of a DISC.

They gave an example, which is identical to the example of this case.

It was an example involving a manufacturer that manufactured four, six, and eight-cylinder engines.

Each was grouped as a separate product line, as it was entitled to be--

Justice Breyer: I'll assume the example was identical.

Mr. Geller: --It is identical.

Justice Breyer: And I will take your words that you have just said.

Mr. Geller: Yes.

Justice Breyer: And I will ask you why a different person quoting those words couldn't make the identical argument in respect to the tremendous tax advantages given to Puerto Rico--

Mr. Geller: Because--

Justice Breyer: --or in respect to the supreme importance of having allocation between Europe and the United States among subsidiaries--

Mr. Geller: --You'd have to look... you'd have to look--

Justice Breyer: --and principal corporations be accurate.

Mr. Geller: --You'd have to look at those statutes.

It may well be that 8(e)(3) couldn't be applied there at all if it would lead inevitably to an incorrect calculation of... of that net income.

But there's something in addition here, Your Honor.

Two things in addition.

First, Justice Breyer, the 994 regulations do not incorporate verbatim all of these 861 rules.

They don't incorporate 8(e)(3).

They don't incorporate... they say that the allocations to be made under section 994 are to be done generally in accordance with the rules under 861.

At the time that that was put in the regulations, the rules under 861 unequivocally provided that there had to be, for every allocation, a direct factual relationship between the expenditure--

Justice Scalia: Yes, but that doesn't mean when... you say in accordance with 861.

Does... does that mean as it now exists, or--

Mr. Geller: --Yes.

Justice Scalia: --861 as it may be amended from... or, you know--

Mr. Geller: I--

Justice Scalia: --as it may be interpreted from time to time by... by--

Mr. Geller: --Not... not--

Justice Scalia: --by Treasury?

Mr. Geller: --I believe, Justice Scalia, not if an aberrational... not if a rule could be put in several years later that's inconsistent with the rules that the tax-writing committees and that the Treasury Department assumed--

Justice Scalia: But that--

Mr. Geller: --would be the 861 rules.

Justice Scalia: --That's a different argument.

That--

Mr. Geller: That excepts--

Justice Scalia: --What I'm saying is it doesn't seem to me, even if you believed in... in legislative history, you can't rely on the fact that they say it's going to be done pursuant to 861.

The Government says, we are doing it pursuant to 861.

Mr. Geller: --But not pursuant to the rules.

This is... if you look, in fact, at the 8(e)(3) regulation, Justice Scalia, it begins by explaining why it's deviating from the general rules of 861, why it felt the need for R&D to deviate from the general rules that require a factual connection between expenditures and revenues.

Now, there's another... there's--

Justice Kennedy: If you... if you want me to say that a regulation drawn after a statute was enacted, another statute, is... is invalid because the intervening statute is... is applicable instead, what... what case do I cite, or what rule?

Is... is the rule just that the specific controls over the general?

I mean, is that all we're talking about?

Mr. Geller: --It is.

It is certainly the specific controls over the general.

It is also the fact that there was a regime here that requires a... accurate calculation of export income.

The rules that were promulgated in 1975 did that.

An aberrational rule was put in in 1977 which we say is inconsistent with the accurate calculation of net income and can't be applied, at least in this context.

But there's another reason, Justice Kennedy, why the 1977 8(e)(3) regulation is inconsistent with DISC, and that's the grouping regulations, which I want to call your attention to, which is a very, very important part of the DISC statute.

If I could call the Court's attention to the grouping regulations which appear at... at 994(c)(7), which is the bottom of page 33a of the appendix to the petition, you will see that the... the taxpayer was entitled to group its products, to figure out export income not in gross, but on the basis of each product or recognized product line, which is what Boeing did here.

And if the Court would look at (6)(iv) in the middle of page 33a, you'll see that the regulations provide that the taxpayer's choice as to how to group is controlling... controlling.

And the regulations go on to say that costs deductible in a particular year shall be allocated and apportioned to the classes of gross income resulting from such grouping.

Justice Kennedy: Now... now, perhaps you can help me here because this is a complicated statute.

Is the Government going to answer that, of... of course, that is... is controlling, but that is only for the purpose of one of the three... of... of one of the three choices that it makes in... and... and it's made the choice to have the combined income?

Mr. Geller: Yes, that's the Government's argument.

But it's completely inconsistent with the words of the regulations, Justice Kennedy.

The regulations say that all of the determinations under (c) have to be made consistent with the grouping, including the allocation of deductions.

So--

Justice Kennedy: And where... where does it say that?

Mr. Geller: --It says it in the language that I just read to you, that the... all... that the costs deductible in a taxable year shall be allocated to the items of gross income resulting from such grouping.

So, here, Boeing grouped its... its classes of gross income--

Justice Stevens: Where were you reading from, Mr. Geller?

I'd like to follow.

Mr. Geller: --Excuse me.

Yes.

Justice Stevens: What were you reading from?

Mr. Geller: I'm reading... I'm reading in the middle of page 33, Justice Stevens, the (iv), the paragraph--

Justice Stevens: Oh, number iv, okay.

Mr. Geller: --which talks about how costs are to be allocated after the taxpayer has chosen particular groupings.

Justice O'Connor: These are the regulations--

Mr. Geller: Under DISC.

Justice O'Connor: --under the DISC scheme.

Mr. Geller: That's right.

Justice O'Connor: Correct?

Mr. Geller: That's exactly right, Justice O'Connor.

Justice O'Connor: And this is how Treasury initially thought the DISC scheme should be--

Mr. Geller: There's... there's nothing in this--

Justice Kennedy: --And you're reading under (iii)?

Sub (iii)?

Mr. Geller: --I'm reading... sub (iv), (iv).

Justice Kennedy: Sub (iv).

Mr. Geller: (iv), Justice Kennedy.

This is crucial.

And if you look at the Eighth Circuit's decision in St. Jude, this is one of the provisions that it referred to as... as showing that 8(e)(3) is completely inconsistent with the--

Justice O'Connor: But the problem is then along come regulations under the general 861 provision governing R&D expenses, and they don't track each other.

So how is it that we--

Mr. Geller: --You have inconsistent--

Justice O'Connor: --don't defer to the Treasury Department interpretation?

That's the sticking point for me.

Mr. Geller: --Well, Justice--

Justice O'Connor: We owe some kind of deference.

Mr. Geller: --I appreciate that, Justice O'Connor.

You don't defer, I think, for several reasons.

First, the language of the statute... it's critical to determine an accurate calculation of export net income.

The 8(e)(3) regulation provides conclusive presumptions in place of factual matching so that it inevitably will lead to an incorrect... and secondly, as I said, the... it was the understanding of everyone, including the Treasury Department when it issued the DISC regulations in 1975, that the taxpayer's choice of grouping would be controlling, that... that allocations of deductions, including R&D deductions, would be... be made on the... on the basis of the taxpayer's grouping.

And when 8(e)(3) comes in, it says, no, no, no.

For R&D--

Justice Stevens: Mr. Geller, on that point doesn't the word grouping, the last word in subparagraph (iv), refer to the three choices in subparagraph (vi) of the... on... on page 32a?

Mr. Geller: --No, no, no.

I think it refers to the... to the choices that are to be made in paragraph (vii) at the bottom of page 33a, and the top of 34a.

The groupings are... you can... you can determine CTI, Justice Stevens, either on the basis of each individual transaction, which would be very, very cumbersome.

Congress understood that and therefore expected that there would be grouping.

The taxpayer is entitled to choose two different ways to group its transactions.

One is by recognized product line... which is what Boeing did here, the 747s, the 767s, the recognized product lines... or basis of SIC code.

Boeing could have chosen to group its transactions by SIC code.

It chose not to do that.

And nonetheless, the 8(e)(3) regulation comes in and insists that although all other deductions can be made on the basis of the product groupings chosen by Boeing, which the regulations say are to be controlling, this one class of deductions, R&D, has to be allocated on the basis of SIC code.

And that's completely inconsistent with the statement in the middle of page 33a that we were talking about that says that all of the deductions are to be allocated on the basis of the taxpayer's grouping, and that that grouping is, in the words of the regulation, controlling.

Justice Scalia: Mr. Geller, I don't want to eat up your... your rebuttal time.

Mr. Geller: That's all right.

Justice Scalia: But... but the Government is going to come back and say, look it, if you did it transaction-by-transaction, we would apply our normal rule under 861.

Mr. Geller: If you did a--

Justice Scalia: You say it's a lot different.

Mr. Geller: --I think the... actually--

Justice Scalia: Would that be correct if they did--

Mr. Geller: --No, no.

It would actually help our argument.

If you did it transaction-by-transaction, you took an individual sale of a 747--

Justice Scalia: --Right.

Mr. Geller: --airplane and you tried to figure out what the export net income was from that sale, it seems to me you would start with the cost of the... of the revenues generated by the sale of that single airplane, and then you would try to figure out what costs were incurred in producing that airplane, including the R&D costs.

You would never, I think, take costs that were incurred that year in trying to develop a 787 airplane, which had no relationship whatsoever to the sale of that 747, and attribute those costs to it in order to reduce the net income.

That's what the 8(e)(3) regulation does.

If the Court has no further questions, I'd like to reserve the balance of my time for rebuttal.

Thank you.

Justice Stevens: Mr. Jones.

Argument of Kent L. Jones

Mr. Jones: Thank you, Justice Stevens, and may it--

Justice Scalia: Mr. Jones, before I lose the thread of... my thread of thought, is it correct what Mr. Geller just said, that if it was done transaction-by-transaction, you would not use the same... the same allocation basis that you're using here?

Mr. Jones: --No.

If it were done on a transactional basis, which is the... the base case provision under DISC, 861 regs would tell us how to allocate costs to the income from that transaction.

And what... I mean, really the... the first point of departure that Mr. Geller made from the statute is that he suggests that only costs... or that any... the costs must be factually related to an item of income to be set off against it.

But that's not the statutory standard.

Justice O'Connor: Well, this is kind of simplistic, but it does seem that in... in the 1970s, Congress wanted to encourage exports, and to do that, they thought they should make some income tax advantages for companies producing products for export.

And that involved allowing grouping of products and favorable income tax treatment which, if you didn't have the... the 861 regulations on R&D, would allow the taxpayer to do what the petitioner is arguing here.

So, it seems to me the argument is that the 861 regs are just so contrary to DISC that they shouldn't govern and don't govern.

Is that the thrust of it?

Mr. Jones: Oh, clearly that's not the case.

The 861 regs were... were formulated for the purpose of determining combined taxable income for DISCs and FSCs.

That's what Congress... that's what the committee said they wanted the Secretary to do under the DISC, and that's what the 861... if you look at 861(f)(1)(iii), it says that expressly.

So--

Justice O'Connor: But 861 applies generally, doesn't it, not just to DISCs?

Mr. Jones: --It... it applies generally, but it was specifically formulated with the calculation of combined taxable income for DISC in mind.

And so it's... it's illogical to suggest, as... as they do--

Justice Scalia: The statute was, or the reg--

Justice Kennedy: --You mean the reg?

Mr. Jones: --I'm sorry.

I meant the reg.

The 861-8 reg was... was formulated with the calculation of combined taxable income expressly in mind, and we know that both by the terms of the reg 861-8(f)--

Justice O'Connor: Well, how do we know that?

Justice Kennedy: Getting back to Justice Scalia's question, and I think it relates to what Justice O'Connor is asking too, is... is your answer to the last argument, that a transaction-by-transaction basis... we would... would clearly not have this problem... is we clearly would have this problem and we'd look at 861, and you'd lose there too?

Or is that not your answer?

Mr. Jones: --Well, that's one way of making the point, but let me... let me address directly--

Justice Kennedy: No, no.

I want to know what your position is.

Mr. Jones: --Well, my position is they've totally misdescribed the grouping provision of the DISC regs, and once you understand it, you will appreciate that the 861-8 regs apply to all of these transactions.

And you can... you can see that by looking at only two pieces of the DISC regs.

The DISC regs, at page 29a in the middle of the page, says, grouping of transactions for purposes of applying the pricing method is provided by (c)(7).

So, you group to decide what your pricing method is, and if they choose the... the combined taxable income method, which they've done here, then you go to (c)(6), which is back on page 33a.

(c)(6) says here's how you determine combined taxable income.

You take the income.

You deduct the costs of goods sold, and then you allocate under provisions of... of section 861 regs.

And then the provision that Mr. Geller cites says... is the (iv) provision, which says you that allocate the costs to the items of income resulting from the group.

That's what the grouping does.

It groups the income, and then against that income, we apply the costs allocated under the section 861-8 regs.

It is--

Justice Scalia: Where is... where that's last language I'm looking for?

It's on--

Mr. Jones: --It's 33 of the petition appendix.

Justice Scalia: --33a, yes.

Mr. Jones: It's the last phrase of the... of the item (iv), and it says that we allocate costs to the income resulting from the grouping.

Now, that's what the grouping is all about.

They're allowed to pick out a series of transactions, group the income, calculate the CTI for the group, so they don't have to file a separate report for a thousand different transactions.

That's all that the grouping is about.

Now, that's been the Secretary's interpretation of his own regulations for 25 years.

And of course, under this Court's precedents, his interpretation of his own regulations is entitled to controlling weight unless it's inconsistent with the provisions of the text of the regs.

And as the Tax Court explained in the St. Jude case, and as I have just described, the text of the reg says you allocate under 861 to the income resulting from the grouping.

Justice Breyer: All right, that's fine.

But he says that... and what you're supposed to do is you're supposed to, I guess, subtract the costs which are allocated to the items of gross income in that group.

Is that what you're supposed to do?

You take the gross receipts in that group--

Mr. Jones: You take the gross receipts for that group--

Justice Breyer: --and you subtract the costs.

Mr. Jones: --and then you allocate costs--

Justice Breyer: Yes.

Mr. Jones: --under 861.

Justice Breyer: Right.

Now, you allocate them under 861.

Mr. Jones: Right.

Justice Breyer: So we go to 861--

Mr. Jones: Right.

Justice Breyer: --and he says, now, if you look at 861, and try to allocate according to 861 to the group that they've picked out, it's seriously nuts, basically.

I mean, imagine that you had a farmer and the farmer raised roses, and he had some fishes, and... and what he has is he does research on fish diseases.

And he says... you'd say, well, my goodness, you're going to allocate his whole laboratory costs which does nothing but fish diseases to the growing of roses because both are farming or fisheries.

Now, is it... something like that is really out of whack, it makes so little sense that that isn't a reasonable method of allocation under anybody's theory.

Mr. Jones: That's... that's a fair synopsis of their position, and... and the defects in it--

Justice Breyer: Right.

So why is it reasonable to allocate the fish disease research to rose culture?

Mr. Jones: --Well, let me start with what the Secretary was supposed to do in the regs, and get to you the answer to your question.

The... the statute on which the regs are adopted doesn't just say you allocate the costs that are definitely related to the product in determining what costs would be charged against it.

It also says you allocate to it a share of costs that cannot definitely be allocated to any particular item of income.

Now, when the conundrum for research costs... and the reason that we have a separate regulation for it is that there's more than one way that research costs are treated under the code.

When research costs are capitalized and amortized over their useful life, they're then properly attributed... as this Court said in INDOPCO... to the revenues as they're received.

But when the taxpayer makes the election that section 174 gives it to take a current deduction, it severs any relationship between the costs and the income.

There is a mismatching, as we say.

There is no proper connection between the costs and the income.

Now, the reason that we need to... the... the... in that case where there is no definite relationship between the costs and the income, the default principle of the statute is that the costs are to be allocated over all income of the taxpayer, not just the income from any specific product, but the income from--

Justice Breyer: He'll grant you all that.

He grants that.

Mr. Jones: --No--

Justice Breyer: But he says, you know, sometimes it is clear.

For example, it is clear that roses don't get fish diseases, and similarly, he says, it is equally clear that... I don't know the factual details, but he says it's equally clear that a 727 research is not as vague as a... is... is different from a 757.

Just the same... roses and fish diseases.

And he says where it's that clear, it's not reasonable for the Treasury to try to pretend that it's vague or hard to allocate, et cetera.

Mr. Jones: --The... a reason why the regulation is reasonable is because if, as I have just said, the statutory default cases... you can apply it against all income.

What the Secretary has said is, well, I'm not going to make you apply it against all income.

I'm going to make you apply it only against a subcategory of income, in this case, the income associated with sales of a product from which foreign sales income might be derived.

Justice Kennedy: Yes, but you use this link... this severance argument, and you say, oh, well, once you do this, you sever the expense from the future income.

I would have thought... please correct me if I'm wrong... that all expenses are... are severed in the sense that all expenses can be used for future income.

Mr. Jones: No.

That's a... that's a fallacy in... in the suggestion of Mr. Geller that mismatching occurs all the time.

It's very rare for mismatching to be tolerated.

For example, if a taxpayer spends $10 building a widget in year 1, and sells the widget in year 2, the $10 he spent in year 1 isn't mismatched.

It's put in the inventory costs.

It's charged as a component of the costs of goods sold in year 2, when the item is sold.

The code is... and the Secretary is very thorough about routinely requiring matching of expenses.

This is an exceptional situation created by the Congress allowing the current deduction, but as Justice Souter pointed out, allowing the current deduction for research doesn't mean that that's... that Congress decided it was definitely related when it was taken.

It clearly isn't definitely related.

And so my... my point was that if it would have been reasonable for the Secretary to just do what the statute says, which is we'll apply it against all income, it's more reasonable, the Secretary decided, to apply it against a smaller category.

And then... and then 5 or 7 years later, the Secretary decided it was even more reasonable to... to apply it against a somewhat narrower category, and we got down to SIC code 3.

Well, these are all alternatives, each of which is reasonable.

They're more reasonable than the statutory default case, the Secretary decided.

Justice Ginsburg: Under code 3, would there be any difference?

It was still transportation equipment as a category.

Mr. Jones: For Boeing, we can go all the way to SIC code category 4, which is planes and parts.

I mean, this... this issue is sort of abstract in this case because whatever, you know, objective test the Secretary had used, it would result in the same in... in this case.

Justice Breyer: Where does the statute say you could just apply it across the board?

By... the statute in 994 that I have just refers to 50 percent of the combined taxable income, and that doesn't define--

Mr. Jones: I'm talking about section 861, which is at page 26a of the petition appendix.

Justice Breyer: --26a, yes.

Mr. Jones: And subpart... part (b) in the middle says that you allocate a ratable part.

It says par, but I think that's ratable part of expenses which cannot definitely be allocated to some item or class of gross income.

So you... and you... you would under the default case make that allocation across all items of income.

Justice Scalia: Well, his argument is that it can... that... that the research on fish can definitely be allocated to fish.

Mr. Jones: If... if it's currently deducted, it cannot be definitely allocated to an item of income.

You see, petitioner just takes two words out of the statute and changes them.

The statute says you allocate costs that cannot be definitely allocated to an item of income.

And he says, well, we allocate costs that are factually related to a product.

Well, that's not what the statute either says, or is about.

We allocate costs to income not to products.

Now, the--

Justice Scalia: It says item or class of gross income.

Mr. Jones: --Right.

Justice Scalia: What is... what is class of gross income?

Mr. Jones: Well, for example, if they group products, they... they group all the sales of Boeing 707s.

Then you allocate the costs to that group based on the costs that can be directly allocated.

Justice Scalia: For that year.

Mr. Jones: --and they share--

Justice Scalia: You're saying it has to be that year.

Mr. Jones: --Yes, and a share of the costs that cannot be directly allocated to an item... to any item of income.

Now, this... the reasonableness of this... of the Secretary's approach is especially clear in light of the alternatives that he faced.

If he had adopted the... the position that petitioner prefers, the result would be that petitioner would claim an expense against a product that was going to be built and sold some other time, and never charge that expense against that product when it's sold.

Now, the obvious and unimpeachable result of that is they overstate their foreign sales income.

And in this case, they do it by $2 billion over the period that's at stake.

They overstate their foreign source income, which has the direct consequence of overstating the... the DISC and FSC benefits that they calculate based on that amount of combined taxable income.

Justice Stevens: But isn't it true, just going back to Justice O'Connor's thought, that... that the consequence... the Government's position is that all research and development cost gets allocated to the DISC when you're in a business like they are?

Mr. Jones: I think that's... I don't understand the factual context of that statement, but the... the answer is all research costs, like every other type of cost gets charged against the income... against foreign sales income to the extent that--

Justice Scalia: Proportionately.

Mr. Jones: --Proportionally, yes, thank you.

Pro rata if it's not current... you know, if it's currently claimed and not capitalized and amortized.

If it's capitalized and amortized... I should just point out because it's... it is a factual point that is worth knowing.

If it's capitalized and amortized, then the costs are recovered as part of the cost of goods sold--

Justice Stevens: No.

I... I understand the distinction between capitalizing it and... and taking it in the current year.

But it seems to me that... that the... the net result of the Government's approach is that... that all of the... all of the research and development expense of the company would be attributable to the DISC.

Mr. Jones: --It would just be attributable to the... to... well, I mean--

Justice Scalia: If... if the DISC is 25 percent of its sales--

Mr. Jones: --If all--

Justice Scalia: --25 percent of its R&D--

Mr. Jones: --Correct.

If all the sales were DISC sales, then... then you would be right.

But if... if some portion of the sales were domestic, which is certainly the case with Boeing, then that portion would be allocated to that portion of the income.

I mean, this pro rata allocation that I've been talking about, that what you're allocating between is the sales that the DISC makes and the sales that the DISC doesn't make.

Justice Souter: --What are the... just out of curiosity, what are the rough proportions of... of overseas and domestic sales?

Mr. Jones: I believe the record says something like two-thirds of Boeing's sales during this whole 10-year period were overseas and, therefore, I assume, made through the DISC.

Justice Kennedy: But just as a housekeeping matter, if Boeing were to prevail here, would it still be open for the Government to say, well, all right, you can allocate along your product lines, but the Blue Sky portion still has to be greatly increased?

Mr. Jones: You mean, would it be open at this stage--

Justice Kennedy: I think I've got the right color.

The Red Sky and the Blue Sky.

The Blue Sky is the general.

Correct?

Mr. Jones: --Yes.

At this stage of--

Justice Kennedy: And that was about some 20 percent.

If... if the... if Boeing prevails, can you still go back and say, okay, you get the product line, but you've got to add another 20, 30 percent to the Blue Sky?

Mr. Jones: --I hate to make a concession that I'm not 100 percent certain... certain about, but... especially since, you know, it... it could be of importance.

I do not believe that issue is open, but it... but if it were, I would reserve our right to address that.

But I don't... I don't know exactly how it would be open.

Justice Ginsburg: Mr. Jones, I thought... maybe I'm confused, but I thought the Government's position was Blue Sky, product-specific... this is R&D and we treat R&D a certain way and we don't buy into that line, which is set by the company.

Mr. Jones: Oh, I agree completely, but... but I understood Justice Kennedy to be saying that if the Court adopted Boeing's approach, would there then be a factual question about what part... whether the Blue Sky amount was accurately described in the record.

And I just don't know for certain.

My assumption is that that's not still open.

Justice Breyer: Is... is it open as to... suppose the... you were to say the following.

Where a taxpayer can show that a particular R&D expense can be definitely allocated to some item or class of gross income, other than the DISC class in this situation or whatever, where they can show that, then the commissioner cannot require them to allocate it to a different item.

Mr. Jones: Well, it... I--

Justice Breyer: That would be just taking the words of the statute.

Now, suppose you said that.

Mr. Jones: --It sounds... it sounds like you correctly described the statute, and let me point out that if they, for example, did their fish research or whatever it was--

Justice Breyer: Yes.

Mr. Jones: --and they capitalized and amortized it to the... to the appropriate products and charged it, then... then they would be entitled to--

Justice Breyer: So... so that's what... that's what I find difficult to reconcile with the 861... 861-8... what is it called?

It's 861-8--

Mr. Jones: --(e)--

Justice Breyer: --(3)--

Mr. Jones: --(3)(i).

Justice Breyer: --et cetera... sentence which says but you have to use two-digit SIC categories because I think they're so broad, those categories, that it should be possible, like my fish example, to find instances where you could.

And why aren't they in that category?

Mr. Jones: First, it only... that only applies if they're deducted under 174.

So... so we've narrowed the issue that much.

And when they're deducted under 174, as I've said, there were a series of reasonable alternatives facing the Secretary based from the statutory default case that you allocated across all income.

Now, the reason I keep stressing that point is because this Court's decisions are very clear that the Court, especially in the context of Treasury regulations, doesn't sit here to decide the wisdom of the particular rule chosen.

It only... in the words of Correll... looks to see whether some reasonable method was applied, not whether this was the best one, or the most logical--

Justice Kennedy: Yes, but it seems to me that what you're doing is... is quarreling with the decision Congress made under 174.

Congress said R&D is inherently something that ought to be capitalized, but we think it's so important, it's going to be expensed.

And you keep saying that, well, you know, really it can't be expensed.

We're going to, in effect, make them capitalize it anyway.

That... that's--

Mr. Jones: --No.

We're... we're not making them capitalize it.

I mean, I would cite, really, my explanation of that as Justice Souter's question earlier, that... which is that the... the decision to allow this current deduction is effective in determining taxable income for domestic purposes.

We don't dispute that there's a deduction, but I'll point out 861... the mere fact there's a deduction doesn't tell you how to allocate it.

And the... 861 says that if the deduction is not definitely related to some item of income, then you charge it against all the items of income.

Justice Scalia: --Can... can I come back to the Blue Sky expenses?

A question that was asked earlier caused me to question my understanding of the case.

As I understand it, Boeing is willing to accept a ratable portion of the Blue... Blue Sky expenses in its DISC.

Right?

Mr. Jones: Yes.

They actually want to--

Justice Scalia: Just a... what it... what it's objecting to is... is those expenses that... you know, that... that go to fish research, those expenses that are identifiable to a particular category.

Mr. Jones: --Just to elaborate, that go to fish research that that... that were deducted currently rather than amortized over the proper future income.

That's... that's what this case is really all about is this peculiarity--

Justice O'Connor: But that's the whole scheme that Congress passed in the '70s to try to encourage exports.

So it just... the interpretation of 861 in the regs seems to go somewhat contrary to the overall purpose of the scheme for DISCs.

Mr. Jones: --Several... several courts have correctly said that the purpose of the... of the combined taxable income calculation is to serve as a limit on the DISC and FSC benefits.

Congress didn't intend unlimited benefits.

They didn't intend to allow benefits of the type that Boeing is seeking where they inflate their foreign source income by not... not putting the costs against that income in calculating it.

And so, the answer to your question is no.

The Secretary's rule is designed to accomplish the correct, in the Secretary's view, determination of combined taxable income for this very purpose.

Now, it... I think that... that the issue that... that may actually be the one the Court wants to consider first is that in 1984, when Congress enacted the FSC provision, it... it in our view ratified and adopted the very cost... research cost allocation regulation that we have in this case.

In... in the Deficit Reduction Act of 1984, there are two provisions that relate to this case.

Congress adopted... enacted the FSC which, of course, is based on the provisions of the DISC, and... and it also contains the combined taxable income method of limiting the... the benefit.

And... and at the same time that they adopted the FSC, they enacted a provision that took one piece of this regulation out and suspended it.

That's the piece called geographic sourcing.

That, for purposes of citation, is 1.861-8(e)(3)(ii).

This case is about 1.861-8(e)(3)(i), which is the rule that calculates combined taxable income.

And when Congress took out... said we're going to suspend this geographic sourcing rule in this regulation, they said, we're not suspending this regulation for application in calculating combined taxable income for DISCs and FSCs.

Well, under this Court's decision in Lorillard v. Pons, that is a ratification and adoption of the regulation.

The Court made the point in Lorillard that when a--

Justice Stevens: Mr. Jones, can I go back for just a second... and be sure I understand something right... to the fish/roses hypothetical?

Am I correct in assuming that the fishes... the research on the fishes would be charged to the DISC only if fishes and roses were in the same SIC grouping?

Mr. Jones: --Under any scenario, that's correct.

Justice Stevens: Oh.

So if they're in a different grouping, then the rose farmer wouldn't have to pay for the fish research.

Mr. Jones: That's correct.

I was assuming you carefully constructed your question.

Justice Scalia: But the... but the grouping can be as broad as... as transportation equipment.

Mr. Jones: It can be quite broad.

Justice Scalia: That's a pretty broad group.

Mr. Jones: It can be quite broad.

But the point is that it's not--

Justice Breyer: And it includes, by the way, agriculture, forestry, and fisheries.

That's one category.

Unknown Speaker: [Laughter]

Mr. Jones: --It's not... it's... the point is it's not as broad as the statutory default rule.

The statutory default rule is by definition reasonable, and the... the narrower rule that the... that the--

Justice Scalia: You've lost me.

The statutory default rule--

Mr. Jones: --Is that you apply these costs against all items of income because they're not definitely related to an item of income.

That's the statutory default principle.

Justice Scalia: --Where is that?

Mr. Jones: That's in 861(b) at page 26a of the petition appendix.

It says that--

Justice Scalia: Got you.

Mr. Jones: --Okay.

Now, on the ratification point, Lorillard v. Pons makes the point that when Congress enacts a statute that's based upon a... a prior... the provisions of a prior act, it is assumed to have adopted the... the administrative interpretation.

Now, that's not a... by itself an overpowering presumption, but what Lorillard pointed out was that when Congress, in doing that, looks at the agency's interpretation and excised a portion of it, the inference that it approved the remaining part is very strong.

Now, here, it's strong not only because of that inference, but because Congress said... I'm sorry... the committee that made this amendment said that they... although they were excising this part about geographic sourcing, that the part about combined taxable income calculations for DISCs and FSCs would remain in effect.

Now, petitioner says, but 2 years later Congress did something that somehow negated that ratification.

Well, of course, the sub... Congress can't change the law as ratified, but that's not what happened in '86 in any event.

What happened in '86 was that the... the committee what was... that was removing the suspension of the... on the geographic sourcing rule said that we're not saying whether the regulation is valid or not.

Well, the regulation that they were talking about was the geographic sourcing rule.

Petitioner says, well, they were talking about the whole rule.

No.

They were talking about the geographic sourcing rule as we know from the last part of that same report which says that nothing in this act has anything to do with the use of these... of the... of the research cost allocation regulations for calculating CTI... combined taxable income... for DISC and FSC purposes.

Justice Kennedy: Correct me if I'm wrong.

In the court of appeals opinion... and it's the paragraph at 12(a).

I think you'll be familiar with this one, where the court of appeals said, the more narrowly a taxpayer chooses to define incomes, the more costs become indirectly or indefinitely related.

Can I be excused from trying to understand that, or--

Unknown Speaker: [Laughter]

Mr. Jones: Well, I can try to help, but I'm... I can't promise results.

It... it looked to me like what they had in mind was the thought that this... that a taxpayer who says my research only relates to wing nuts on... on this plane is... is defining it so narrowly that it's not realistic.

And... and indeed, the record of this case reflects that... that research on one type of plane has applications on other types of planes.

And... and I think what the court was addressing there was his view that... that this was an appropriate accommodation.

This was one of the choices that the Secretary had.

It was a reasonable choice.

Justice Kennedy: It really was restating the problem rather than offering a specific solution.

Mr. Jones: I think it was restating the problem in a way that indicated it felt that the Secretary's choice was a reasonable one.

Justice Ginsburg: Mr. Jones, can you tell us this continuing significance of this arrangement?

I... we're now past the successor of the FSC.

Is that true?

Mr. Jones: Yes.

The FSC is no longer with us.

It was replaced by the extraterritorial income provisions... maybe in '98.

I'm not sure.

Justice Breyer: What about the two-digit SIC?

Is that still with--

Mr. Jones: Two-digit is... it was replaced by the... the narrower three-digit band in '94, I believe.

Justice Breyer: --So if we thought the two-digit was a little bit going too far, would that throw open all kinds of claims on the... on the... from all kinds of people?

Mr. Jones: Well, I mean, again, if the Court wanted... felt it needed to look at the two-digit versus three-digit, although to me they're just, you know, spectrums along the--

Justice Breyer: The degree of specificity... well, at least three-digit would separate the roses from the fish.

Mr. Jones: --This case really doesn't present the question--

Justice Breyer: It doesn't.

Mr. Jones: --because, as I said, there's just... is... there's no question that Boeing goes all the way to SIC 4.

And so if the standard is are the products reasonably related, which... which is--

Justice Breyer: So we don't have to consider it.

All we'd have to--

Mr. Jones: --I don't think you have to consider it, but if you did, I think you would do it in the context of realizing these are reasonable alternatives, and that the Secretary didn't have to pick the best one.

He just had to pick one of them.

And I... if you thought that none of these were reasonable, then... then, you know, it wouldn't matter which one he picked.

Justice Breyer: --At some point they certainly--

Mr. Jones: If there are no further questions, thank you.

Justice Stevens: --Thank you, Mr. Jones.

Mr. Geller, you have a little over 2 minutes left.

Rebuttal of Kenneth S. Geller

Mr. Geller: So much to say.

Justice Kennedy, I think you put your heart on the... on the Government's... the... the problem with the Government's position here.

It's simply an unwillingness to accept the fact that Congress created a number of incentives here that were not designed simply to raise revenue.

They had other purposes such as the export... the... the beneficial treatment of export income and also the immediate deductibility of... of R&D.

Now, the Government tries to defend this regulation here on the... on the basis that there's this temporal mismatch and it's all the result of not capitalizing.

I should say a number of things about that.

First, this was not the basis for the regulation at the time the regulation was issued.

It was not the basis for defending this regulation in the lower courts.

And it... and the Government's position is not even consistent with that regulation because if the whole problem here is the lack of a temporal mismatch, you would think that if you had a class of gross income in which in a particular year there was both revenues and R&D expenses, well, in that situation there's no temporal mismatch.

They would at least allow you to allocate those R&D expenses to that revenue in that year.

No.

Even if there's revenue in a class of gross income in a particular year, they still insist that those R&D expenses be spread across all of the income in that SIC code.

Now, I want to mention St. Jude, because in this case we're dealing with airplanes and airplanes, and while the... the costs are specifically allocated only to particular programs, it gets a little more complicated.

But look at St. Jude.

In St. Jude, you had a manufacturer who was exporting artificial heart valves.

That's all it was doing, is manufacturing and exporting artificial heart valves.

In the same year, it was engaging in R&D for insulin pumps, and for pacemakers.

The Government insisted that the export income from the sale of those heart valves be reduced, and that the DISC benefit be reduced because of the R&D spent on these other products that obviously had no basis or relevance to the sale of the heart valve simply because they were all within the broad... same broad SIC code.

And I should say, Justice Kennedy, the Ninth Circuit's opinion I think is somewhat unintelligible.

The... the part that you... you referred to, we all stumbled over because it makes no sense.

The more narrowly... the more narrowly you define your classes of gross income, the more that... that costs will be directly allocated to more than one class of income.

It's not a question of anything being indirectly allocated.

And there's no default rule at issue here either because all of our costs are directly allocable to specific programs.

That's all we ask that we be allowed to do.

We ask that the judgment in the Ninth Circuit be reversed.

Thank you.

Justice Stevens: Thank you, Mr. Geller.

The case is submitted.

Attribution:

The Oyez Project

Featured:

United States v. Fior D'Italia, Inc. - Oral Argument

Fri, 09 Jan 2009 14:50:27 +0000

Case:

United States v. Fior D'Italia, Inc.

Media File:

01-463_20020422-argument.mp3

Related Transcript:

transcript.xml

Transcript:

ORAL ARGUMENT OF EILEEN J. O'CONNOR ON BEHALF OF THE PETITIONER

Chief Justice Rehnquist: We'll hear argument first this morning in Number 01-463, United States v. Fior D'Italia.

Ms. O'Connor.

Mr. O'Connor: Mr. Chief Justice, and may it please the Court:

This case is about the authority of the Commissioner of Internal Revenue to assess FICA taxes that Congress has imposed on employers.

It also involves the well-established principle of tax litigation.

It involves two key sections of the Internal Revenue Code and how they relate to each other, and it involves the evidentiary value of assessment in tax litigation.

The first of the key sections is section 6201.

It appears at page 62a of the appendix to our petition.

It authorizes and requires the Secretary of the Treasury to make inquiries, determinations, and assessments of all taxes imposed by the Internal Revenue Code.

The second key section is 3111.

It appears at page 55a of the appendix to our petition.

This section imposes a tax on employers.

The tax is measured by the wages they pay or are deemed to have paid their employees.

Unidentified Justice: Which section is this, Ms. O'Connor?

I'm--

Mr. O'Connor: Section 3111 at page 55a of our appendix to the petition.

Unidentified Justice: --Thank you.

Mr. O'Connor: This is the tax that imposes... this is the provision that imposes a tax on the wages employers pay or are deemed to have paid their employees.

The question this case presents is how the commissioner carries out his obligation under 6201 to assess the tax that is imposed by section 3111.

The tax is--

Unidentified Justice: Ms. O'Connor, let me tell you what troubles me a little about the Government's position in the case, and I hope you will address this.

How can an employer ever challenge effectively an assessment made under the position that you approach, because the normal burden of proof in a tax refund case normally requires the employer to show exactly how much money was owed, and I don't see how that would work in this context.

Mr. O'Connor: --Exactly, Your Honor.

The Congress has recognized the difficulty that employers have in this regard, and that is the reason there are several of the other sections that we will discussing this morning.

Section 6205, for example, is mentioned in your materials.

That is a provision that permits employers on their own, if they discover an error, to correct it later and have no interest assessed.

That's a very unusual provision, and it relates specifically to the complexity of employment taxes and their administration.

Unidentified Justice: Well, would that error ever be anything more than a disparity between what the employee reported and what the employer reported?

Mr. O'Connor: Would what, Your Honor?

Unidentified Justice: How... I mean, the error that that section... I'm wondering what the error is that that section contemplates, and I can see it's application, let's say, if the employer simply added up the employee's reports wrong and got the wrong figure.

Under what other circumstances would it apply short of the moment at which the Government makes the assessment which is in question here?

Mr. O'Connor: It could also apply just... and 6205 is not specific to restaurants or food or beverage establishments or tips at all, because another common error that employers can sometimes make is mischaracterizing a worker as an independent contractor, for example, and upon determining later that the person is actually an employee and they should be withholding FICA--

Unidentified Justice: Well, let me ask the question in another way.

How would it... how could it apply in this situation?

In other words, as I understand it... I mean, this is... I didn't mean to side-track you from Justice O'Connor's question, but I'll raise the thing that bothers me.

As I understand it, what the employer is obligated to report is the sum total of all the reports that the employees give to the employer of tip income.

Mr. O'Connor: --That's right, Your Honor.

Unidentified Justice: And I'll assume for the sake of the question that a given employer has done that.

Mr. O'Connor: Mm-hmm.

Unidentified Justice: I also assume that if you are correct, that employer has this possibility hanging over it that the IRS is going to make this kind of an assessment.

Mr. O'Connor: That--

Unidentified Justice: Is there any... my question is, is there any way that the employer can anticipate this kind of an assessment in order at least to avoid the interest running under this section?

Mr. O'Connor: --Absolutely.

There are many different ways, Your Honor, and this case provides a very good example.

Employees are required to report on a monthly basis to employers.

You can see from the forms 8027, which are at pages 38 and 39 of the joint appendix, those are the forms that this restaurant filed for 1991 and 1992.

Unidentified Justice: And they were all correct, I take it.

Mr. O'Connor: Right, those forms were absolutely correct.

You will also note at the top of the page it says that it is an information report, because this is information that Congress has required food and beverage establishments to provide to the Internal Revenue Service exactly for a purpose such as this.

Now, the annual... the information report at pages 38 and 39 is an annual report that the food and beverage establishment provides to the Internal Revenue Service, but employees provide reports to employers at least monthly.

You will see on the forms 8027 that 90 percent of the sales of this restaurant were paid for by credit card, so every single month this restaurant could have compared the tips that employees were reporting with the tips that they saw were being charged on credit cards, and as any business owner would do when faced with a liability that could occur down the road, you're going to set up a reserve for it.

You know you have got your annual insurance premium due next January.

You start setting aside for it.

Unidentified Justice: He may set up... the employer may set up a reserve, but as I understand it the employer is not obligated, in effect, to withhold upon himself, is not obligated to pay the tax on it until the assessment comes, because under the IRS' instructions the employer pays the tax on the amounts reported to the employer even if he knows they're wrong.

Mr. O'Connor: That's exactly right, and that's another indication of the fact that Congress realized that this was going to be a difficult provision for employers to enact.

Unidentified Justice: Well, what would he do--

Mr. O'Connor: 31--

Unidentified Justice: --What would he do to anticipate it?

Would he say, I'm paying you another $10,000, I don't happen to owe you that in tax now, I paid what the law requires me to pay, and you haven't assessed anything else, but here's another $10,000?

I mean, is that what you're anticipating?

Mr. O'Connor: --Absolutely not, Your Honor.

In fact, it is the rare taxpayer who seeks to pay his tax before it's called for.

[Laughter]

Unidentified Justice: All right, then how does the taxpayer take advantage of the provision that allows him to make a correction and avoid the interest in this case?

Mr. O'Connor: Well, one of the things that is somewhat troublesome about some of the briefs in front of you from the other side is that the other side is looking at this as though it was a penalty, and it's not a penalty, it's merely a tax.

In fact, there specifically are no penalties.

Let me point out--

Unidentified Justice: I will assume... no, I will assume it's no penalty.

I just want to know how it works in this situation.

He doesn't owe any tax--

Mr. O'Connor: --Right.

Unidentified Justice: --based on what he has to report to you.

Mr. O'Connor: Right.

Unidentified Justice: You haven't assessed anything yet.

How can he possibly take advantage of the provision that allows him to make a correction, to pay in accordance with that correction, and to avoid any interest that he would otherwise be liable for?

How can he take advantage of it?

Mr. O'Connor: Well, let me point out a couple of things from your question, Justice Souter.

First, let me direct you to 3121(q).

Provisions of the Internal Revenue Code provide a couple of things.

They provide what is tax, how is the tax measured, when is it measured--

Unidentified Justice: Where is 2131(q)?

Mr. O'Connor: --3121(q) is in our joint appendix here... oh, no, no, it's in the petition.

Thank you.

3121(q) is at 58(a).

Thank you very much.

Unidentified Justice: General O'Connor, it might help if you answered specifically whether interest does run on the period between the employer paying what the employee's reports call for and the assessment at a higher amount.

Mr. O'Connor: Thank you, Justice Ginsburg.

No, there is no interest that runs, and that's why I wanted you to look at 3121(q) in particular.

Unidentified Justice: Then how does this section have an application here?

You say, well, this mitigates it, and--

Mr. O'Connor: No, I'm sorry--

Unidentified Justice: --it seems to me that about all the employer can do is pay immediately at the moment of your assessment and therefore no interest will run.

Mr. O'Connor: --No, I did not mean to suggest that 6205 applied to this assessment, and in fact it doesn't.

6205 applies when the employer himself discovers an error and corrects it at the next available opportunity.

Unidentified Justice: So it wouldn't apply in these circumstances.

Mr. O'Connor: It doesn't need to, because under 3121(q)... it's a very interesting provision.

3121 provides definitions, that's all.

It resides in the subchapter of the Internal Revenue Code that provides for these employment taxes, and (q) is the definitional provision that says that tips are wages.

It also tells you when the tips are wages.

For the purposes of the employer FICA 3121(q) tells you that the wages are deemed to have been paid when the employee reports them or if the employer... employee doesn't report them, they are wages deemed to be paid when the IRS issues notice of demand, so until the IRS notifies the restaurant that there is an additional FICA tax due, there is no interest or penalty.

Unidentified Justice: Right, but at that point there is, and if you would come back to Justice O'Connor's question, which was, how could the employer ever know that there was a mistake in the assessment, and you said, well, as soon as he knows it, he can come forward with the additional amount and there won't be any penalty, but how does he know it?

That's the problem.

Mr. O'Connor: He knows it because the employees are reporting on a monthly basis, and in this case there was clearly... we have $120,000 of unreported credit card tips in each of the 2 years involved here, $120,000 in unreported credit card tips.

Those reports were coming in every month.

The restaurant has clear notice--

Unidentified Justice: But your assessment is for more than that.

Your assessment assumed a certain unreported amount of cash tips as well.

Now, how is the reporter... how is the employer going to know whether that's erroneous or not?

Mr. O'Connor: --The same method that he would use to make any other determination.

For example, he knows by the basis of the report that all credit card tips are not being reported.

Unidentified Justice: But the burden is on him.

The burden is on him to show what the proper amount was.

I mean, IRS comes up with a guess based on, well, we assume that the same amount weren't reported for cash tips as weren't reported for credit card tips, pay up.

Now, how is he going to prove that there was a different amount for--

Mr. O'Connor: You're exactly right, Justice Scalia, the burden is on the taxpayer, and in this case the taxpayer conceded the entire amount of the judgment.

Page 35 of the joint appendix--

Unidentified Justice: --But the burden is on the taxpayer to give information as to which the taxpayer is not in the best position to know, and--

Mr. O'Connor: --That's true, Justice Kennedy.

Unidentified Justice: --Justice O'Connor's original question was, how is the employer supposed to know, and you say, well, if he doesn't know he can amend later.

The whole question is, and the gravamen of the argument put forth by the taxpayer here is that the assessment should be on the person, or on the entity that has the information, and here your information is as good as the employer's, and you have the ability to do what the employer can't, i.e., subpoena the individual records of the employees.

Mr. O'Connor: Actually, not all of that is true, Justice Kennedy.

The employer, if there were a dispute between the employer and the employee the employer certainly could subpoena records of the employee in a matter such as that, and respondent, as you say, does--

Unidentified Justice: How does he do that, sue the employee?

Mr. O'Connor: --Oh, if... yes, if there were a dispute between the two over any matter the employer certainly could.

Unidentified Justice: You're talking about a tax court or a district court, or--

Mr. O'Connor: No, just as a general proposition.

Just as a general proposition.

In this case--

Unidentified Justice: --Well, as a general proposition I don't think the employer can subpoena the employee.

I mean, you have to have a legal proceeding, don't you?

Mr. O'Connor: --Oh, exactly.

That's what I mean, Your Honor.

If there were some other legal proceeding--

Unidentified Justice: Well, but I mean, that's not going to work.

You're suggesting that he ought to fire the employee and then be subjected to a wrongful discharge suit and then subpoena the information so that he can give it to you.

Why don't you just ask for it?

Mr. O'Connor: --Well, actually, there is no evidence in the record on whether the individual employees were audited or not.

I saw that in the Ninth Circuit opinion, TRAC is asserted on that point.

Unidentified Justice: But the point is, you have the capacity to do it and the employee doesn't.

Mr. O'Connor: That's true, Justice Kennedy.

The amount of assessment, though, I think it's very important to focus on the fact that in this case, as you can see at page 35 of the joint appendix, the taxpayer here conceded the reasonableness of the assessment, conceded it.

Unidentified Justice: Then that's just luck, because I thought Justice O'Connor's original question was, look, we can all do this, it's so simple.

You multiply 14.3 percent times the gross receipts of every restaurant in the country, all right.

Now, I thought her question was, what is the restaurant owner supposed to do to show that that's inaccurate, what can he do, and so far my own conclusion listening to you is, he can write the check.

Mr. O'Connor: I'm sorry, I didn't mean to--

Unidentified Justice: Now, is there anything else... is there anything else that this restaurant owner has it in his power to do, other than write the check, and not some theoretical thing.

What I'm interested in is the practicality of it.

Mr. O'Connor: --Absolutely, Your Honor--

Unidentified Justice: What is that?

Mr. O'Connor: --and I don't mean to be avoiding the question.

Let me point to another line on the form, 8027.

You'll notice there is a line that refers to 8 percent, and then there's a blank and it says, or lower percentage.

The reason for that is that if a restaurant employees are reporting tips that are less than 8 percent of gross sales, that could raise a red flag that maybe the restaurant worker--

Unidentified Justice: It's not about 8 percent.

Everybody knows all these minimums.

This is about people who are earning more than the $20 in tips per year.

Mr. O'Connor: --Right, per month.

Unidentified Justice: It is about people... per month, or whatever.

Mr. O'Connor: Right.

Unidentified Justice: It is about people who satisfy all these other minimums.

It is not about people... they can even get a tax credit for this.

Mr. O'Connor: Right.

Unidentified Justice: I'll save that question.

Mr. O'Connor: Right.

Unidentified Justice: I'm interested in the answer to Justice O'Connor's question in what I'd call the mind run, mainstream, basic, typical situation, and that is, what is that answer?

So far I'm concluding he can do nothing.

Mr. O'Connor: No.

Unidentified Justice: Tell me the answer.

Mr. O'Connor: What the restaurant can do is show evidence that would tend to determine, or help determine the amount of the tip, how many... what kind of a restaurant you have, how upscale it is, where it's located, the kind of meals you serve... in fact, the IRS has a procedure where restaurants can show all that information, a sample menu to get below the 8 percent.

Unidentified Justice: And then I'm not being clear.

Mr. O'Connor: Right.

Unidentified Justice: I think in typical cases like this one, the restaurant will have paid more... they will have assumed that it is more than 8 percent.

They wrote a check for... they assumed it was $200,000.

That's going to be more than 8 percent of gross receipts.

Mr. O'Connor: Right.

Unidentified Justice: All right.

Now, we're only talking about an area that's well above that, and in respect to the area well above that.

Here it happened to be between $200,000 and about $350,000.

In respect to that extra $150,000, you come in and say, we're sure that it was earned in tips, and now here's what you did.

You multiplied gross receipts by 14.3 percent, and you subtracted the $200,000, okay.

I'm saying anyone can do that, and I thought Justice O'Connor's question was, you are a restaurant owner.

You are faced with this.

How do you show that it isn't so?

Mr. O'Connor: The taxpayer here had the opportunity to do that.

One of the things that you--

Unidentified Justice: Well, but will you acknowledge at least that it's virtually impossible for the taxpayer to get that information?

I mean, the taxpayer has the reports from the employees, and they're false.

Mr. O'Connor: --What--

Unidentified Justice: How, as a practical matter, is the taxpayer going to establish there's something different?

I mean, we know in terms of generalities, we're told that there are less tips paid, or bills paid in cash than by credit card.

Mr. O'Connor: --That has been an insertion that is unproven in the record.

Unidentified Justice: So you don't accept that as proof.

Mr. O'Connor: It may or may not be true.

Unidentified Justice: So what's the employer going to do, then?

Mr. O'Connor: It may or may not be true.

Unidentified Justice: Let me ask you one other thing.

There's a so-called TRAC system, right, that Congress passed to address this very problem.

What percentage of restaurants have used TRAC?

Does the record tell us that?

Mr. O'Connor: No, the record doesn't tell us.

I understand from news reports that increasing numbers of employers are entering into the tip rate alternative commitment, and that is an alternative to justifying or trying to establish... in this case, though, let me point out that at any point during the IRS' examination the taxpayer could have shown, could have produced information that would have reduced the number that you see on Exhibit A.

They never did that--

Unidentified Justice: But where would he get--

Mr. O'Connor: --and they didn't do it in the district court, either.

Unidentified Justice: --Where would the taxpayer get the information?

The only thing the taxpayer has got are the employee's returns to the taxpayer and your assessment.

Where is the taxpayer going to get the information that would allow it to do what you say in theory it could do?

Mr. O'Connor: Well, magically, since its concession in the district court, at the appellate level and again in its briefs before this Court, the respondent has come up with all sorts of ideas that might challenge the amount of the assessment.

Even if the--

Unidentified Justice: But there is a stipulation in this case... whatever may be in the next case, there is a stipulation in this case that they are not contesting the method.

I have a question that I think Justice Breyer has said he was reserving, and that is, I don't understand what's in this for the revenue, because of the... the provision you haven't mentioned, 45B gives the restaurant a credit against income tax, dollar for dollar, for the FICA tax, and let's assume we have employers, most of them are paying at least the minimum wage, what gain is there to the revenue whichever way this comes out?

Mr. O'Connor: --We don't know whether the taxpayer here was paying the minimum wage, because none of that was in the record, because the assessment amount was conceded.

The 45B credit, as you point out, is available only for tips that are not used by the employer to satisfy his minimum wage obligations, yet it's not a complete wash to the Treasury, however, because you still have the FICA tax being paid in and an income tax credit being given, so it's the trust fund accounting that would have a problem if you look at it as a complete offset.

From the Government side it's not a complete offset at all.

Let me emphasize that the concession in this case--

Unidentified Justice: Excuse me, I didn't understand that.

Mr. O'Connor: --Yes.

Unidentified Justice: Go over that again.

What trust fund?

Mr. O'Connor: The social security trust fund, so to speak.

Unidentified Justice: So to speak, yes.

[Laughter]

Mr. O'Connor: Well, it is a matter of Government accounting.

As a matter of Government accounting.

Unidentified Justice: It's a fantasy, isn't it?

I mean, it all goes into one pot, doesn't it?

Mr. O'Connor: As a matter of Government accounting, there are funds that are--

Unidentified Justice: Purely as an accounting matter it makes a difference, is that it?

Mr. O'Connor: --As a Government funding matter.

As a Government funding matter.

Unidentified Justice: From the point of view of the taxpayer it makes no difference, I take it?

Mr. O'Connor: From the point of view of the taxpayer, it will make a difference if they use tips to satisfy their minimum wage requirement, and on this record we don't know.

Unidentified Justice: And if they don't, it won't make that... a difference.

Mr. O'Connor: It will... well, no, that's not entirely true, but it's an optional credit.

The employer can prove his eligibility for the credit and claim it, or rather than claiming the deduction, they can claim a tax deduction, which they might prefer to do.

Unidentified Justice: What happens if the employer doesn't have enough, I guess, gross income to offset?

Then he has to be stuck with the difference, right?

Mr. O'Connor: Well, it is a nonrefundable credit, and that means you can either use the credit as an offset to your income tax, and what you're suggesting is they don't have any income tax.

That kind of employer might prefer to take it as a deduction, which would create a net operating loss which could carry forward and benefit a future year.

Unidentified Justice: But the question... and to overstate the point... I'm not buying into this argument at the moment, but I do want to hear your response.

From their briefs I have the impression that it doesn't make a lot of difference to the Government in this case.

It would make a lot of difference to the Government in the case of restaurants that are losing money, in the case of taxicabs, hairdressers, newspaper boys, and anyone else who is in a business where people receive tips, and in respect to those kinds of cases it gives the Government a weapon.

In this case, it's being used to force them into a TRAC program that they don't want to enter.

In some other case, to have a kind of threat that you could make to people because, of course, a lot of income is underreported through tips, and you'd always be able to go out and assess more.

Now, you're asking us to interpret some very broad language as saying Congress has given you authority to do a particular thing.

They're saying, don't give them that authority.

Congress would never have intended the IRS to do what I've just described.

Now, I want to be sure you have a clear opportunity to answer that, because I want to hear what the answer is.

Mr. O'Connor: Congress had the opportunity to say that no, the IRS does not have the authority to do what has been referred to here as aggregate assessment, and I might just point out here that rather than aggregate assessments, which is what the respondent calls what has happened here, respondent would prefer the individual audits and aggregating the estimates, because certainly they would be estimates if they were done on the basis of the individual waiter's reports also.

But in 1998, when Congress said that the IRS cannot use a threat of an assessment like this to force restaurants into a TRAC, it clearly had the opportunity to say, and besides, you don't have the authority to do these estimates anyway, these assessments anyway.

The authority is very clear, and the only thing that the respondent has ever argued here is that the amount might be wrong, and they can't tell you exactly what it is, but there is no rule that an assessment has to be entirely accurate or precise.

The assessment authority requires inquiries and determinations, and that's what's happened here.

Unidentified Justice: The assessment is presumptively correct, isn't it, under the statute?

Mr. O'Connor: Not under the statute, Justice Rehnquist, Chief Justice Rehnquist, but rather under the laws that this Court has observed.

In United States v. Janis, this Court commented on the presumed correctness of assessments and their evidentiary value in tax litigation.

Unidentified Justice: Well, you take the position it is presumed to be correct, don't you?

Mr. O'Connor: It is... United States v. Janis stands for the proposition that an assessment is valid unless it is without any foundation.

Clearly, here, when the assessment is based on the respondent's own report, and more than three-quarters of the assessment is on the amounts that are clearly known to be true, clearly this foundation, this assessment has a foundation.

Thereafter, once you've established that the assessment is not invalid, that it has a foundation at all, then you start talking about the amount.

Unidentified Justice: Well, I wonder--

--No, please, go ahead.

Well, it has a foundation if three-quarters of it is true?

Mr. O'Connor: Pardon me?

Unidentified Justice: It has a foundation if three-quarters of it is true?

Mr. O'Connor: Oh, no.

Unidentified Justice: Is that what having a foundation means?

Mr. O'Connor: The test under Janis I think is much, much lower than that.

It's... an assessment is valid if it has any foundation at all--

Unidentified Justice: So if--

Mr. O'Connor: --and clearly, this one has a foundation.

Unidentified Justice: --1 penny on the dollar is accurate, that... it has a foundation?

Is that what it means?

It couldn't mean that.

Mr. O'Connor: Oh, I think that would be pushing it a little far, Your Honor, and that's not what United States v. Janis requires.

Unidentified Justice: I would think it would mean that there's some reason to believe the full amount is accurate, not that three-quarters of it is accurate.

Mr. O'Connor: That's not what this Court has held, particularly United States v. Janis, where in fact the assessment there was based on an estimate of wage-earning practice.

By looking at 5 days' worth of wages the commission assessed on 77 days worth of wages.

Unidentified Justice: Sure, but doesn't the Janis rule assume that the taxpayer is, in fact, in a position to prove the correct figure if the assessment is wrong?

Mr. O'Connor: Not necessarily, Your Honor, and it is incumbent upon any taxpayer upon whom a tax is imposed to maintain whatever books and records they can.

Unidentified Justice: Exactly, and that comes back to the question I've asked before.

What can this taxpayer do?

Mr. O'Connor: Well, the taxpayer is in a business that requires a lot of things.

There health, safety, and sanitation regulations.

There are also tax-reporting regulations.

You hire reliable people, you tell them what the rules are, you remind them what the rules are, and you facilitate their compliance, and that's what the restaurant here needed to have done, and may even have done.

Since they didn't challenge the assessment or amount of the assessment, I think we can assume that--

Unidentified Justice: Well, short of the restaurant's hiring someone to bird dog every single waiter and waitress to see what, in fact, the tip was, I don't see how the employer here could collect the information.

The gambler, sure, he can write it down in his little book, but I don't see where the employer here is in a position to get the figure to write down in a little book, short of having a third person follow every--

Mr. O'Connor: --The waiter can also write down his tips in a little book, and there are--

Unidentified Justice: --Sure, and the whole premise of the problem is that the waiter is in fact not telling the whole truth.

Mr. O'Connor: --That is why restaurants--

Unidentified Justice: I mean, that's just really impractical.

Mr. O'Connor: --every employer should hire reliable people who they can trust to follow the rules.

[Laughter]

I'd like to reserve the balance of my time for rebuttal.

Unidentified Justice: Very well, Ms. O'Connor.

Ms. Power, we'll hear from you.

ORAL ARGUMENT OF TRACY J. POWER ON BEHALF OF THE RESPONDENT

Mr. Power: May it please the Court, Your Honor:

Congress did not saddle the employer with a tax while depriving him of any way to defend against it.

Congress did not require the employer to do what for 30 years it told him it was not required to do.

This tax is not authorized.

Because it's not authorized, that affects the burden of proof and the presumption of correctness.

I'd like to suggest an analogy.

If Congress had passed a tax on my chickens and the IRS came along and said, we're imposing a tax on you, on your neighbor's cows, and I said, but I don't owe a tax on my neighbor's cows, and they in turn said, yes, well, what we did was, we figured your neighbor had X number of acres and therefore the average number of cows per acre is Y, and you owe the tax on the cows, and I said, well, I'm not going to fight that because I don't have any way to know how many cows my neighbor had.

Unidentified Justice: But can I just ask one question that really puzzles me in this case?

[Laughter]

I can't follow the cows and all--

[Laughter]

Mr. Power: I understand.

Unidentified Justice: But you did have records, written records that showed that the actual amount of tips paid by credit card and so forth to the people in question here was substantially larger than you reported.

Why shouldn't that put you on notice that you owed a little money to the Government?

Mr. Power: We do not know to what extent, if any, those credit card tip amounts, or the amount on the credit card tip slot on a credit card, was in fact received by an employee, a tip received by an employee that is wages subject to the act.

We do not know what--

Unidentified Justice: Well, but after those credit cards go to the restaurant, doesn't the restaurant turn the cash over to the employee?

Mr. Power: --The restaurants handle it in a variety of different ways.

It could be as simple as an employee at the end of the night starting to turn over all the money he's collected during the night, first to satisfy all the credit card bills, then to satisfy all of the dupes for the food that he had with the balance remaining in his pocket, which he then turns around and kicks out to a whole host of other employees.

We do--

Unidentified Justice: But don't you know what the practice is in your own restaurants?

Mr. Power: --We would know what... each individual restaurant would know what is done in basic practice in their restaurant, but how much, if any, of that credit card amount was retained by any individual, we do not know.

Unidentified Justice: No, but what may... I understand the waiter may have split the tips with the busboy and so forth and so on, but the total amount of tip on the credit card slip was paid to some employee, was it not?

Mr. Power: Well, we don't even know whether it's a tip.

There are many reasons why it might not be a tip.

Unidentified Justice: But this is a particular restaurant.

I mean, it 's not as if we're talking about the world of restaurants.

Surely this particular restaurant knows.

Mr. Power: Would know whether that credit card amount was, in fact, a tip?

No.

You could have well had a circumstance--

Unidentified Justice: You mean if it's shown on the credit card--

--As a tip--

--as a tip... I seem to recall seeing a space--

--Yes.

--on restaurant charges--

[Laughter]

Mr. Power: --That's correct.

Unidentified Justice: --that says, tip, X amount.

You fill it in.

Mr. Power: And that's correct, and if I went in and I didn't have any cash in my pocket and I said to the waiter, you know, I'm going to leave some extra tip on here, I need to pay for the valet when I leave, I'm going to put $5 extra on here, can you give me the cash... yes, it's possible that there's tips on there.

Unidentified Justice: The question isn't possible.

The question is what's normal, and normal tip is tip, and I don't understand the chickens and the cows exactly--

[Laughter]

In my copy of the code here it says... it doesn't say... it says the employer, there is imposed on the employer an excise tax equal to 6.2 percent of wages, and it says, including tips, so I don't see how... what your argument is that the tax isn't authorized.

Of course it's authorized.

Mr. Power: But it's wages of an individual employee.

Unidentified Justice: Yes, that's right, and the employer has to--

Mr. Power: It's wages... and they have, what their assessment stands for is a tax on my gross tip payroll.

There has been no... that is not a tax--

Unidentified Justice: --No, no, but I... I understand that basic point.

I'm trying to get you to focus on what I think would be, despite the rights and wrongs of it, their very strong legal position, which is very simple.

Number 1, that there is assessed here a tax on the employer equal to 6.2 percent of the total, including tip wages of the employee, all right, and they say, we have the power under the statute to assess the amount, and moreover, we think your client didn't pay, and therefore we took what we think was a very reasonable way of figuring that out.

We looked at the credit cards and we saw it said, tips, and we saw 14.2 percent is the typical amount, and we assume that's it for credit and for cash, and if you don't like that, you prove to the contrary.

We don't think you can prove it, not because it just isn't possible, that probably, in all likelihood, it isn't true, okay.

Now, that's their point.

Now, you reply to that.

I would like to hear your argument.

Mr. Power: --My reply to that is, we started out by saying it's wages, including the tips of the employee, and they did not give us a bill for wages which are the tips of the employee.

They gave us a bill for the total gross tips of all employees collectively, and this Court has already held that FICA taxes are divisible taxes under Flora v. United States, that it is a tax imposed upon the individual wage earnings.

This Court has already interpreted 3111 to be a tax on individual wage earnings, and they did not give us a bill for that tax.

Unidentified Justice: Well, but that's a different argument from the one that we've been wrestling with, which is whether or not you have within your authority and control an ability to calculate the basis for challenging the assessment.

Mr. Power: We do not.

Unidentified Justice: And you began by saying, well, they differ and, frankly, I don't give much force to that argument.

The employer knows how the employer distributes credit card receipts.

That's the employer's job, so I'm not particularly persuaded by that argument.

If you want to go ahead and say, well, the cash portion of the tips don't relate to the... in the same ratio that the credit card tips, I would understand that.

Mr. Power: The employer does not know how the tips, the credit card tips are distributed.

It's not as if--

Unidentified Justice: Doesn't the employer get the credit card receipt?

Mr. Power: --At the end of the--

Unidentified Justice: And doesn't the... the employer can st up any system the employer wants.

Mr. Power: --At the end of the evening the employer would cash out all the employees and would turn over credit card tips to employees who might have received credit card receipts, and those employees would then decide among themselves to whom in what amount they are going to share those tips that they have received, along with any cash tips that they may have--

Unidentified Justice: But the employer at least has an aggregate at that point, some that appears from the credit cards to have been paid out in tips, no matter how it's shared.

In addition, he has the ability... in addition, he has the ability to tell his employees that he wants to know the ratio in which they're shared.

He can make that a condition of employment, so I'm not persuaded by that argument.

Mr. Power: --I don't really think he can make that a condition of employment.

I think that employers have to be very careful what happens in the context of wage and hour laws and tip-pooling regulations and so on and so forth.

Unidentified Justice: Well, that seems to me all the more reason why the employer should have a strong interest in knowing how the division is being made.

Mr. Power: Well, I think that there are many employees who do not want the employer to have anything to do... to know... to do with the tip-sharing arrangements.

It is... tips are the property of the employee.

Not only that, you have--

Unidentified Justice: But the employer, Ms. Power, has an obligation to pay FICA tax, and has an obligation to pay it on the total earnings, and it isn't... your cow analogy didn't just pass me by, because the tax on the employer is independent of the tax on the employee.

Suppose these employees never paid a cent in FICA tax, and they went off to beach-comb some place, the FICA tax would be owed by the employer just the same.

Mr. Power: --That's correct.

Unidentified Justice: So it's the employer's cow.

The FICA tax belongs to the employer.

Mr. Power: The... there is no question that the employer owes a FICA tax.

He owes the FICA tax regardless of whether the employee is ever audited.

He owes the FICA taxes regardless of whether the employee is ever assessed or the employee ever pays his taxes.

It can be assessed against the employer at a completely different time from when it can be assessed against the employee.

The employer does not dispute that he owes a FICA tax.

What the employer disputes is, I can't know what I owe that FICA tax on until you make some determination of what the individual earnings are, because until that time, I am denied all defenses employees have that they can raise, and there's a whole list of long--

Unidentified Justice: But you know what... in fact, you stipulated that you don't dispute the facts, the estimates, or determinations used by the IRS as a basis for its calculation of an amount of aggregated unreported tip income by all directly and indirectly tipped employees, which is your... is on page 35 of the joint appendix.

You agreed that you are in this case, for purposes of this case not disputing any of that.

Mr. Power: --I do not... we do not dispute the amount of the IRS' aggregate assessments because... of all employees collectively, because we simply do not have the information to dispute that.

Congress has prohibited us from having that information.

We do not have that information.

We have never had that information.

Congress for 30 years has told us we do not have to concern ourselves with that information, and we do not have the wherewithal to dispute it.

So in this case, do I dispute that?

No, because it is not worth disputing that or attempting to even whittle down that assessment in this case.

Unidentified Justice: But your position is, we know that there is a disparity between what is reported and what is actually paid in tips.

We know that both the employee and the employer independently owe a tax on that total amount, and we know about the shortfall, but there is nothing the Government can do.

It's just stuck by what the servers put down on the monthly form that they file.

Mr. Power: There's plenty that the Government can do.

The Government has the wherewithal to do everything, and that's exactly what Congress says should be done.

Unidentified Justice: Well, the only thing that you've proposed, and tell me if I'm wrong about this, is that the Government go one by one after the employees, and am I correct in saying that the same method would be used by the Government if it went against an individual server, that it... you are resisting the Government using against the restaurant.

That is, let's take a waiter in this establishment.

The Government says, you've underreported your tip income, and the way we figured out that you've underreported it is the same formula.

Isn't that what goes on when--

Mr. Power: No, it's entirely different, because... and as the McQuatters case that's cited in the briefs by both parties illustrates, in that circumstance, the individual waiter has an opportunity to bring any defenses that he has to the Government's assessment forward, and we are denied every possible defense by that scenario.

Unidentified Justice: --Well, take... make that specific, please.

Here is a waiter, and the Government says, you have unreported income, and this is how we've estimated it.

We've estimated it based on our formula, and then specifically what does that employee do when the Government says, we've made an estimate based on this 14 percent, or whatever it is?

Mr. Power: The employee disputes the estimate.

Whether he does it at an administrative level or whether he goes to the tax court and disputes it, he goes in and he disputes it, and he raises the issues, and I think a number of them were identified in the waitresses' amicus brief.

For instance, they say, well, I didn't work as long.

I don't have the same experience as the other guy had.

They was stiffing, a tremendous amount of stiffing.

We had a European clientele, the tips weren't as great as you think.

Unidentified Justice: What is stiffing?

Mr. Power: No tip whatsoever.

[Laughter]

I'm sorry.

Unidentified Justice: I just don't understand how any of that can get you below the amount that shows up on the credit cards, because for example, say one employee got $2,000 in tips, and he could have a defense that I passed out $600 to the busboys, and maybe his liability is less, but it still seems to me the employer would have to at least pay the aggregate amount on the credit card.

Mr. Power: No, because--

Unidentified Justice: I just don't understand how you get around that.

Mr. Power: --there's a situation where you could have many employees.

There's a very high turnover rate, especially with those who are in the categories that receive the least amount of tips.

Somebody who comes in, and he's a busboy and he's there for the afternoon, and he says, boy, forget this job, I'm leaving, and he takes the tips that he gets that day, and that happens at a much higher percentage--

Unidentified Justice: Well, that would explain why assessments might be wrong as to individual employees, but it still doesn't reduce the gross amount in the tip column on the credit card.

Mr. Power: --It does reduce the gross amounts--

Unidentified Justice: How?

Mr. Power: --that the employer would have to owe, because if any of that credit card tips that you're assuming isn't in fact a tip was received by somebody who made less than $20 a month, the employer doesn't owe any tax on that.

Unidentified Justice: Okay.

That's a possibility, but wouldn't it suffice on any rule of probability if the Government did just what Justice Stevens described?

It's quite true, yes, there might have been an extraordinary turnover, if there is, the employer can come in and say so.

But if the Government made its claim simply based on what the credit card reports showed, wouldn't the Government have made an assessment which enjoyed at least a probability of accuracy?

Mr. Power: No, because you go back to 3111 and Congress did not impose a tax on the aggregate earnings of all employees collectively.

Unidentified Justice: So your argument there is that even if you had the perfect evidence, even if there was a memo beyond dispute, written by the accountant and signed by all the employers that said, after the most thorough investigation of this restaurant I'm telling you privately, and you agree, that the total tips earned that are eligible for social security are $350,000, so it's signed by 15 bishops, you know, absolute, dead right, we're saying that even if that's so, he still doesn't owe it because in the memo it doesn't say which employees.

Mr. Power: I think that it needs to say which employees learned which amount, and that's what the tax was imposed upon, and if on the other hand you had all of the employees say yes, I earned this, yes, I earned this, yes, I earned this, then you would have that individual determination.

Unidentified Justice: But there's never been anything held, is there, that where an employer clearly owes a tax to the Government, based because of the earnings of the employee, and there can be different contexts where that comes up, the evidence that he owes that has to name or pick out which employee?

I assume if there were a case that ever said that you would have cited it, and I doubt that there is.

Mr. Power: I don't think that there is.

Unidentified Justice: All right.

If there isn't, then that's my problem.

If you're talking about the quality of the evidence, you run into the problem that Justices Stevens and Souter mentioned.

If you're talking about the need for the precision identification of a single employee, I don't see in the law any requirement for such a principle.

Mr. Power: I think that it's in 3111.

I think that this Court has already held that the tax is imposed upon--

Unidentified Justice: But whereabouts in 3111?

If it's just two sentences, tell us what sentence or what clause you--

Mr. Power: --Well, 3111, it says wages or... 3111 says wages... I'm sorry, Your Honor.

Equal to the following percentage of wages as defined in section 3121(a), the tax imposed on something called wages, that is defined in 3121(a).

You cannot read 3121(a) as anything but--

Unidentified Justice: --Where do we find 3121(a) in your brief?

Mr. Power: --It's on the next page, page 56 of the Government's appendix to the petition, and it says, the term wages means all remuneration for employment, and it goes on... they only have one of the individual terms listed.

There are 21 specific--

Unidentified Justice: But you're telling us this shows your point, and you... point to the language that you think it does.

Mr. Power: --3111 imposes a tax on wages--

Unidentified Justice: On wages.

It doesn't say individual... wages paid to each individual.

It says wages.

Mr. Power: --It says wages as defined in 3121(a).

Unidentified Justice: Then we turn to 3121, and where is it in there that it makes your point?

Mr. Power: When you go through each one of the 21--

Unidentified Justice: Well, that's what we're here for, to go through something.

Mr. Power: --Okay, well, the 21 exceptions to 2131(a) lists individual things like whether an employee participates in a health insurance plan, whether an employee has a 401(k) plan, the extent to which an employee's wages go above or below the social security wage base.

Unidentified Justice: But that goes to the accuracy of the figure, perhaps, which you said really is not your point.

That... none of those exceptions say anywhere, collectively or in specific terms, that under 3111 you can't add them all up.

Mr. Power: Well, this Court has already held that--

Unidentified Justice: And that's what we're saying.

Mr. Power: --that's not the way the tax works.

This Court has already held in Flora v. United States and as quoted in Steele v. United States that it isn't a tax on the aggregate earnings.

It is... the assessment is an accumulation of separate, divisible taxes on each transaction.

What is subject to the tax is each individual payment--

Unidentified Justice: There are two Flora cases, neither of which are cited in your brief.

Which Flora... there was a rehearing grant.

Which one are you--

Mr. Power: --Flora v. United States, and I believe it's footnote 37 in Flora v. United States.

Unidentified Justice: --Yes, but there are two Flora v. United States that a rehearing was granted, one's 357, one's 362, and your brief doesn't seem to mention either of them.

Mr. Power: Well, we referenced them in our complaint, Your Honor.

I think it's paragraph 14 of our complaint.

Unidentified Justice: Does it give a citation there?

Mr. Power: Yes, Your Honor.

362 U.S. 145.

Unidentified Justice: But that was just about whether or not the tax court had jurisdiction if the assessment wasn't completely paid beforehand, wasn't it?

Mr. Power: Yes, but I believe that footnote 37 in that brief, in that opinion said that the Court agreed that the excise tax, like a FICA tax, is a divisible tax.

That's the whole basis upon which we're here.

We only paid $18 of the total tax, and we paid it on the basis of our estimate, although we cannot prove it one way or the other, of one employee who would have made less than $20 a month over a period of time.

If this wasn't a divisible tax, or one that was imposed upon each transaction of wages, then we would have had to pay the entire $23,000.

This hold that it is a tax on an accumulation of all wages of all employees is to change that 40-year history of--

Unidentified Justice: Now, Congress passed something called the TRAC law in 1998 to deal with this very problem of tips and the FICA tax, did it not?

Mr. Power: --Not technically, Your Honor.

TRAC is not something that Congress passed.

TRAC is something that is an agreement between the industry and the IRS.

It was... I was the first person who approached the IRS on coming up with some type of an agreement with the IRS to solve this problem, and the TRAC agreement was a contract that was written between--

Unidentified Justice: I thought there was a section in 1998 passed by Congress, section 3414 of the Internal Revenue Service Restructuring and Reform Act providing that IRS would not threaten a taxpayer audit to coerce the taxpayer into entering a tip-reporting alternative commitment agreement, so at least Congress acknowledged--

Mr. Power: --Congress acknowledged--

Unidentified Justice: --the agreement, did it not?

Mr. Power: --It acknowledged that the agreement existed, but Congress--

Unidentified Justice: Do you think Congress was assuming there were assessments going on of employers for this liability?

Mr. Power: --Not at that time, because there are two documents at the very end of the joint appendix that are Government documents, and they indicate that they were not doing the employer-only assessments at that time.

In fact, they indicate that they were not doing the employer-only assessments at that time.

In fact, they indicate that they... they assured Congress that they were not doing assessments at that time.

Unidentified Justice: When did the IRS start doing these aggregate assessments?

Do you know when they started?

Mr. Power: I would say that they started doing them about 1992, 1993, and you had asked the question earlier, how many TRAC agreements are there that have been signed.

There are about 25-to-30, 000 TRAC agreements that have been signed.

There are about 200,000--

Unidentified Justice: Well, this congressional provision that I asked you about was made in 1998, so that was well after the beginning of aggregate assessments.

Mr. Power: --And long after the IRS had announced that they were not doing aggregate assessments.

Unidentified Justice: The gravamen of your brief is that as a principle an assessment shouldn't be imposed on the taxpayer unless the taxpayer has the information to contradict the assessment, which certainly makes a lot of common sense.

Is there a provision in the code, or something that we've said in the cases that sustains that overarching principle?

Mr. Power: Well, I think that--

Unidentified Justice: Or is it just kind of a due process fairness thing?

Mr. Power: --Well--

Unidentified Justice: Is there a specific principle you can point to to show the correctness of that assumption?

Mr. Power: --Well, I think that there's 30 years of congressional history that clearly shows that Congress does not intend for the employer to be put in this position, that Congress did not intend for the employer to be required to police and monitor the reporting of employees, and ostensibly that's what the IRS' interpretation does.

Unidentified Justice: But you have no specific authority or precedent for the proposition that an assessment should not be imposed on a taxpayer unless the taxpayer is in a good or perhaps best position to contradict the assessment?

Mr. Power: I think that we have plenty of authority for the proposition that the assessment in this case is unauthorized because it's on the collective wage-earning on 31--

Unidentified Justice: But that wasn't what I asked you.

I asked you about the general proposition.

Mr. Power: --That a tax cannot be imposed upon--

Unidentified Justice: An assessment cannot be imposed on the taxpayer unless the taxpayer has the capacity or the ability to contradict it.

I mean, that's... it seems to me that's the principle argument in your brief.

It makes a lot of sense, but I want to know if I'm... if the Court's writing an opinion for that, what do they cite for that proposition?

Mr. Power: --The best I can tell you--

Unidentified Justice: Other than the fact that this is something everybody should know, but that doesn't usually work.

[Laughter]

Mr. Power: --I think that the burden of presumption and the burden of proof that they have put forth is premised upon the understanding that the person with that burden has the records and is in the best position to respond, and that does not characterize this situation, so those policy considerations behind that are not existing here.

Unidentified Justice: Are there other situations in the tax law where the Government knows that income has been underreported?

Aren't estimates made in many different contexts where the taxpayer doesn't keep reliable records, and so the Government has to find some way of measuring what the tax should be, so it does an estimate?

Isn't that common?

Mr. Power: In each one of those cases it's... the person responsible for keeping the records is the one taxed.

We have no problem with the IRS attempting to determine the earnings of the individual employees and coming back and--

Unidentified Justice: Well, you did before, because when I asked you, are they making an estimate in that case, and you started to say no, because the taxpayer, the individual servers have all these--

Mr. Power: --Excuses--

Unidentified Justice: --Yes.

Mr. Power: --or defenses?

Unidentified Justice: Yes.

But I thought that they could... I thought that was a given, that if they go after a single waiter, that they can have an estimate.

Mr. Power: They can.

Unidentified Justice: They do make an estimate.

Mr. Power: They can.

Unidentified Justice: And the very estimate that you are resisting when it applies to the employer.

Mr. Power: Because we are... we don't have the same defenses that the waiter and the waitress does.

The waiter and the waitress can say, you know, all kinds of things in response, that no, I didn't earn that, here are my records, here are my individual records of exactly what I earned.

The IRS sends them a bill based on the same types of estimates, takes it one step further and says, okay, well, you worked X number of hours out of the total number of hours in this restaurant, so of this total share we think your share is this amount.

The waiter or waitress can come in and say no, here's my individual record, and this is exactly what I earned, or no, you're wrong in assuming this, or you're wrong in assuming that, and then a determination can be made of what that individual waiter or waitress made, and then turn around and give it to us.

That's exactly what one of the documents in our joint appendix on page 92, that's exactly what the IRS did do before they came up with this aggregate assessment method, because that is precisely what Congress envisioned that the IRS would be doing with the 8027 Form data, is taking that information, using that information to make examinations of individual employees, and then turning around--

Unidentified Justice: Now, practically can the IRS... are you suggesting that they go after the employees, and then when they know the amount based on the extra tax the employee will have to pay, then say, okay, employer, you pay the same amount, but practically can the IRS... does it have the facilities to go audit every waiter and busboy and--

Mr. Power: --There's no requirement that they audit every waiter or busboy.

In the first place, that letter that I just pointed out didn't require any audit at all, and not only that, in the context of what's happening here, they still have an audit problem.

They've only collected, or are attempting to collect 25 cents out of every single dollar.

They're leaving three... 75 cents on the table here.

They come in here and they say that they've got this huge, astronomical problem, and we can't do anything about it.

Unidentified Justice: --Well, the reason is, maybe it isn't cost-effective to go after the individual employees.

Mr. Power: Well, I don't think it's very cost-effective to do this one, when the employer is--

Unidentified Justice: The employer tax is owed independently, which is what I started to ask you about when you gave your cow example.

The taxes on an employer, that's a discrete tax.

There's a tax on the employee.

That's a discrete tax.

Why, because the Government is going to have a hard time collecting the tax on the employee, is it disabled from collecting the tax on the employer?

Mr. Power: --Because that's what Congress said--

Unidentified Justice: Thank you, Ms. Power.

Mr. Power: --that the IRS should do.

Unidentified Justice: Ms. O'Connor, you have 3 minutes remaining.

Ms. O'Connor, at the very outset you said that 311 imposed a tax on wages paid or deemed to have been paid.

Is the word deemed in the statute?

REBUTTAL ARGUMENT OF EILEEN J. O'CONNOR ON BEHALF OF THE PETITIONER

Mr. O'Connor: Is the word deemed in the statute?

Unidentified Justice: Yes.

Mr. O'Connor: I believe so.

I believe it's in 3121(q), Your Honor, which I keep losing.

Unidentified Justice: Well, I'll find it.

Mr. O'Connor: Yes, it's on page 58a, is where 3121(q) appears, and remember that is a section that provides definitions.

3121 tells you that wages include tips which are paid or deemed to have been paid, and 3121(q) also tells you the time.

As we have said, this is a tax on an aggregate amount.

Form 941 in your joint appendix show how the employer reports the tax, and shows that it is a tax on the wages paid.

Unidentified Justice: Well, except I think the deeming refers to the time of payment, not to the fact of payment, but I'll look at that.

Mr. O'Connor: I think you're right about that, Your Honor.

Nonetheless, they are deemed to be paid at the time, right.

3121(q) tells you that tips are included, and then the deemed part is... the tips are wages, and the deemed part is when they are deemed to have been paid.

They're deemed to have been paid by the employer, and then it goes on and tells you when.

It does say tips are deemed to have been paid by the employer.

That's the very first sentence.

It's at page 85a.

Unidentified Justice: How long has IRS been making these assessments, please, Ms. O'Connor?

Mr. O'Connor: I believe, Justice O'Connor, that it did start around 1992 and 1993, and the information that the IRS is gathering on the forms 8027 demonstrated the extent of the problem that Congress suspected did exist about substantial underreporting of tip income.

Unidentified Justice: In view of all the questions about the proper computation, why has the Government resisted notice and comment rulemaking to come up with a fair formula, because the contention is that the Government's formula exaggerates the income, exaggerates the tip income.

Mr. O'Connor: That is certainly the contention, and there have been, however, no facts to show whether that's true or not, because in each of the cases, not only the Ninth Circuit below, but in each of the three cases that we cite in our briefs decided by the Seventh, Eleventh, and the Federal Circuits, no evidence was ever submitted to show that the tips were overstated in any way.

Unidentified Justice: But why not... why not employ that fair procedure of going through the notice and comment, and then... I think that's what Judge Kozinski said to do.

Mr. O'Connor: Yes, he did.

Judge Kozinski's opinion entirely excludes section--

Chief Justice Rehnquist: I think you've answered the question.

Judge Kozinski did say that, so the case is submitted.

Attribution:

The OYEZ Project

Featured:

United States v. Craft - Oral Argument

Fri, 09 Jan 2009 14:50:23 +0000

Case:

United States v. Craft

Media File:

00-1831_20020114-argument.mp3

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transcript.xml

Transcript:

ORAL ARGUMENT OF KENT L. JONES ON BEHALF OF THE PETITIONER

Chief Justice Rehnquist: We'll hear argument now in Number 00-1831, United States v. Sandra Craft.

Mr. Jones.

Mr. Jones: Mr. Chief Justice, and may it please the Court:

The question in this case is whether the Federal tax lien that applies by operation of law to all property and rights to property of a delinquent taxpayer attaches to the interest of that taxpayer in a tenancy by the entirety.

The taxpayer in this case was an attorney who, for 10 years, failed to file a Federal income tax return and accumulated a Federal tax obligation of approximately half a million dollars.

At the time the taxes were assessed and the notice of tax lien was filed, the taxpayer owned a real property in a joint tenancy by the entirety with his wife.

He then conveyed his interest in that property to his wife for $1, and when his wife then sought to sell the property the tax lien appeared in the title record.

Mr. Sutton: Now, tell us about the fraudulent conveyance proceeding.

Does the fraudulent conveyance holding, or finding, make no difference one way or the other?

If it was a fraudulent conveyance the husband has the property... you can... well, if it was a fraudulent conveyance, you can pursue the property, and if it wasn't, the lien is still there anyway under your theory.

Is that the way it works?

Mr. Jones: I think that we would say that the lien, the question of the validity of the lien is the first question.

If the lien is valid you don't need to address the fraudulent conveyance question.

Indeed, we haven't presented the fraudulent--

Mr. Sutton: Right.

Mr. Jones: --conveyance question in this case.

If the lien were not valid, it would still be possible to go after property in certain circumstances if there had been a fraudulent conveyance, but on this record we're not challenging the determination that as a matter of State law there was not a fraudulent conveyance, except for this fraudulent enhancement portion that the court awarded.

Mr. Sutton: Mr. Jones, as part of the background, how did it come about that it's only the taxpayer who has the liability?

Did she file separate returns, or was she an innocent spouse?

Mr. Jones: In this case, the taxpayer is the husband.

The husband was an attorney, and he filed no return, and when... there's two ways for this issue to come up.

Either spouse may file either no return, or file only a separate return.

It's only when they file a joint return that they are jointly and severally liable for the tax obligation, so if, as in this case, the taxpayer simply files no return at all, then the obligation is exclusively that... the tax obligation is that of the nonfiler, in this case the husband.

Indeed, Judge Ryan pointed out in his separate opinion that the decision of this Court, of the court of appeals is very amenable to abuse, because on this theory both spouses can earn income, neither of them can file a return, or they can both file a separate return, and then they can put all of their real and personal property in a tenancy by the entirety, including stocks and bonds in States like Michigan and Maryland, and claim a complete exemption of all of their property from Federal tax obligations.

Now, in--

Mr. Sutton: --some penalties for failing to file a return?

Mr. Jones: --There are some penalties, but the penalties, like taxes, have to be enforced against the property of the taxpayer, and if the taxpayer is allowed to exempt all of its property in this fashion, then there's literally no way that the taxes can be enforced through civil procedures.

Mr. Sutton: What about criminal procedures?

Are there any criminal procedures for--

Mr. Jones: I--

Mr. Sutton: --failure, continued failure to file--

Mr. Jones: --Of course, if you file a return, then you're not exposing yourself to any criminal obligations, and if you don't file a return, it would be... I'm not familiar with a statute that makes that a crime by itself.

Now, it may be that it's a crime in connection with some intent to conceal, but just the fact that you didn't file... I'm not... frankly, I'm not... even though I come before the Court on tax cases, I'm not an expert on criminal tax matters, but it's my impression that that would not by itself be a crime.

Now, the Federal tax--

Mr. Sutton: --We'd better not let the word get out.

I thought that it was a crime, but I'll check.

[Laughter]

Mr. Jones: --All right, well, I stand--

Mr. Sutton: We'll keep it just among ourselves.

Mr. Jones: --I will defer all questions on title 18 to Justice Kennedy.

I'm simply not--

Mr. Sutton: Do we know as a matter of fact what her situation was?

Did she not file also?

Did she file a separate return?

Mr. Jones: --I don't know whether she had any income of her own.

I don't know whether she was required to, whether she did file a return... this case does not involve this... the wife's taxes.

It involves the half-million dollars of taxes of the husband.

Mr. Sutton: Yes, I know.

I was just curious how that came about.

Mr. Jones: I don't believe the record reflects.

Now, the comprehensive text of the Federal tax lien reaches not only all property of the taxpayer but all rights to property of the taxpayer, and this Court has consistently held that this broad text shows a plain intent to reach every type of interest that a taxpayer might have in property, and two terms ago in the Drye case the Court summarized these holdings and said that the Federal tax lien reaches every species of valuable, legally protected right or interest of the taxpayer, and the simple question that we have before us today is whether a taxpayer who has an interest in a tenancy by the entirety has any valuable legally protected interest in the property.

Mr. Sutton: Well, of course, isn't the issue whether the taxpayer has a legal interest in the property?

Isn't that the issue?

Mr. Jones: That is the underlying issue in this case.

Mr. Sutton: And the other side says no, there's this mythical entity called the marriage, or something like that, is the owner.

Mr. Jones: Well, it's a real entity.

There is really a marriage.

It's just that the property interests are, in fact, owned by the individual spouses, as I can explain by going through what rights a tenant by the entirety has under the applicable law in this case, which is Michigan law.

A--

Mr. Sutton: But are any of those rights legal rights owned by the taxpayer.

Mr. Jones: --Yes.

Mr. Sutton: That's the basic question.

Mr. Jones: Yes, and indeed, in fact, the supreme court in Michigan has so held.

Let me just describe these rights that the taxpayer has.

The individual owner of the... each spouse in a tenancy by the entirety has the right to occupy and use the premises, has the right, with the consent of the other spouse, to mortgage or sell it, and under section--

Mr. Sutton: Wait, wait.

Strike that one.

I mean, that's... the marriage can sell it.

I mean, with the consent of the other one is just to say--

Mr. Jones: --This is--

Mr. Sutton: --tenancy by the entirety.

It's the marriage that sells it.

Mr. Jones: --That is exactly the interest that the taxpayer had in the Rodgers case in a homestead estate.

He could not sell his properties separately from that of his spouse.

He could only mortgage or sell it with the right, with the concurrence of the spouse, and what the Court held in Rodgers--

Mr. Sutton: But he had a legal interest in the property.

Mr. Jones: --Yes, he did.

Mr. Sutton: He did.

Mr. Jones: Yes, and if I might go on, there are more interests involved.

I mean, even if you wanted to stop there, we can't stop there, because the taxpayer in fact has greater interests than the ones we've already described.

Under section 557.71 of the Michigan Code, which is quoted at page 41 of the joint appendix and page 3 of our reply brief, each spouse in... since 1975 each spouse in Michigan has had the right to equal portion of the income from the property, that is, the interest, the dividends, the rents, to the profits, and is entitled to half of the proceeds on the sale of the property.

Each spouse under Michigan law is entitled to half of the property on divorce, and has a right of survivorship that gives him the fee simple, absolute--

Mr. Sutton: Presumably the Government could get a lien on any of those things if they ever came into being.

Mr. Jones: --They are in being, and that's what the supreme court of Michigan pointed out in Dow v. State.

The court held that these significant interests in property possessed by each spouse are property for purposes of the constitutional Due Process Clause, and that each spouse must separately be given notice of any action affecting their significant property interests.

Mr. Sutton: Given notice by whom?

Mr. Jones: Of any action that might be brought with respect to the property.

In other words, under the Due Process Clause you have to have notice and an opportunity to be heard if there's property affected, and what the court said is that these significant... I'm quoting.

These significant interests in property of each spouse entitle each of them to separate notice, because they have separate rights.

Now--

Mr. Sutton: How did that case come up?

I mean, was somebody suing the tenants by the entirety, or--

Mr. Jones: --My recollection is that it was a foreclosure-type case.

Now, the pecuniary right of each spouse to half the income and half of the proceeds on the sale is an ordinary kind of right to money.

It is a quintessential--

Mr. Sutton: --May I just interrupt you once more?

You, in describing the case, said that each of them was entitled to notice because each of them had a separate right in the property.

Is that what the State court said--

Mr. Jones: --Yes.

Mr. Sutton: --or is that your sort of interpretation?

Mr. Jones: It said that... the words... well, I don't have the text in front of me.

It said the separate--

Mr. Sutton: It makes a big difference.

They're each entitled to notice--

Mr. Jones: --Each spouse--

Mr. Sutton: --which is... because each had a separate right--

Mr. Jones: --It says each spouse is entitled to separate notice--

Mr. Sutton: --Right.

Mr. Jones: --because they have a significant interest in the property, and--

Mr. Sutton: Mr. Jones, you're not asserting that the Government's lien gives it any greater right than he has, so the recitation that you had, you're not saying that the Government lien means that they could preempt her right, are you?

Mr. Jones: --No.

We're saying that we have those rights.

In fact, in this case that is the issue.

There was the sale.

There was a consensual sale of the property.

Half of the proceeds were placed in escrow.

Half were given to the wife as her undisputed 50-percent share, half were placed in escrow pending determination of the validity of the lien.

That's what this case is.

It's that--

Mr. Sutton: Would the case be any different if that transaction you just referred to hadn't taken place?

Would the Government's case be weaker?

Mr. Jones: --The Government's case would be significantly different if the sale had not occurred.

Then we would presumably be waiting to see what happened, or we would under Rodgers be attempting to bring a foreclosure case.

We haven't attempted to do that here because we didn't need to do it and, in fact, we rarely do, and while I'm on the foreclosure issue, let me point out that Rodgers held that a joint interest can be foreclosed notwithstanding that neither spouse by themselves force the sale of it.

What the Court explained was that Congress specifically provided in 7403 of the code that the foreclosure applies to the entire property, and that in that sale the rights of the innocent spouse are protected and, indeed, the court, the district court has discretion not even to order a foreclosure if it so chooses.

Mr. Sutton: But--

--Well, let's assume you do foreclose because we find that, indeed, the husband has a property interest in the tenancy by the entirety, so you foreclose.

Now, I guess some of his interest you've just pointed out is a right to half of the income from the property, but surely his most significant interest is that he is entitled to half of the whole property if the marriage dissolves, right?

Mr. Jones: Or of it's sold, and he's entitled to all of it if he's the survivor.

Mr. Sutton: Right.

These are all contingencies, okay.

How do you... you foreclose... how do we value these contingencies?

Mr. Jones: This--

Mr. Sutton: What do we... we have people come in and say how stable the marriage is, or what?

Mr. Jones: --This Court discussed that exact, what the Court called the practical reality in the Rodgers case, and gave a detailed example that I think took three or four pages of the Court's opinion in Rodgers, explaining how you would value the respective interests of the parties.

Let me also suggest to the Court that there is a very thorough and thoughtful decision of the district court in New Jersey in United States v. Jones in 1995 that discusses the circumstances when discretion would not be exercised to allow foreclosure of tenancy-by-the-entirety property, and the Court concluded that there were circumstances which that case was one, where instead of foreclosing on the property, the property rights of... the United States would simply be put in the position of holding the right of survivorship of the delinquent spouse, and in addition, the right of that spouse to half of the rents would be recognized immediately on behalf of the United States.

The foreclosure remedy, I've heard cases describe it as a drastic remedy.

Well, I don't know if it's drastic, but it's a remedy that doesn't have to be exercised, and that there are cases that explain circumstances when it's appropriate in the court's view not to do so.

Mr. Sutton: But in your view, you always value the taxpayer's interest at 50 percent?

Mr. Jones: No.

I think in the Rodgers... well, if the property's been sold, yes.

If the property hasn't been sold, and we're talking about in a foreclosure context, I believe the Rodgers court goes through the example of the varying life expectancies of the two tenants, and which one... and I believe what the Court in Rodgers said was that each of them should be treated as if they have a life estate plus a right of survivorship, and the Court explains how that could well... I think in the facts of Rodgers resulted in only 10 percent of the proceeds being applied to the husband's interest and 90 percent being retained on behalf of the spouse, but--

Mr. Sutton: But there must be a foreclosure to that extent?

Mr. Jones: --There... that was a... I believe those were hypothetical facts that the Court discussed in Rodgers.

Mr. Sutton: Mr. Jones, during the continuance of the marriage can either spouse force a sale?

Mr. Jones: No, and that was the point made in Rodgers also, that in any kind of joint tenancy... by the way, I should emphasize--

Mr. Sutton: But I thought joint... I may be wrong in this.

I thought a joint tenancy could be converted into a common tenancy by the action of one--

Mr. Jones: --I misspoke.

It's not in every joint tenancy.

It is a common feature of joint tenancies that they can't be forcibly sold by one and, indeed--

Mr. Sutton: --During the continuance of the joint tenancy.

Mr. Jones: --Correct, and that that was the case in Rodgers--

Mr. Sutton: Okay.

Mr. Jones: --where the homestead right could not be--

Mr. Sutton: But I take it from your earlier answer that there is, in tenancies by the entirety there is no such legal means of converting that tenancy into a tenancy in common which then can either be the subject of a forced sale or petition, is that correct?

Mr. Jones: --I believe that's correct, and I believe it was also true in Rodgers of the homestead estate, which is a common... which is also a common estate.

In fact, in this Court's opinion in Jacobs in 1939, where the Court said that we were not... the Federal tax laws were not bound by the ancient fictions of tenancies by the entirety, the Court pointed out that a joint tenancy and a tenancy by the entirety create the same rights.

The only difference is the fiction of the marital unit, and the Court held in the Jacobs case, as it had held 9 years earlier in the Tyler case, that that feudal fiction or ancient fiction did not bind the tax provisions, that the tax provisions were to be implied in light of the actual rights of the tenants and not based upon the artificial rules of State law, and then in Irvine and in Drye just two terms ago this Court, in interpreting the term, property, and rights to property and Federal tax legislation and in the lien statute said that we look to the realities of the taxpayer's right, and we're not struck blind by legal fictions of artificial--

Mr. Sutton: But the realities of taxpayer rights depend on State law, don't they?

Mr. Jones: --The realities of the taxpayer's right are drawn from State law, but we're not supposed to... I mean, in the words of the Court, let the artificial rules of State law blind us to the realities of those rights, and let me give you--

Mr. Sutton: Well now, what's the difference, do you think, between the artificial rules and the realities?

Mr. Jones: --Well, this Court has said that difference can be seen in tenancies by the entirety, that the realities are that the tenants... I mean, it is a fiction.

The respondent admits it's a fiction.

Every--

Mr. Sutton: Well--

Mr. Jones: --The word fiction is what is implied here.

Mr. Sutton: --You say it's a fiction.

What do you mean by it?

Mr. Jones: What is a fiction is the idea that neither spouse actually owns an interest in this property.

That's the fiction.

Mr. Sutton: So is a corporation a fiction, but we don't tax the shareholders for income of the corporation.

It's a fiction acknowledged at law and--

Mr. Jones: It's a legal entity.

It has an existence.

The marital unit is the fiction.

Mr. Sutton: --So is the marriage--

Mr. Jones: The marriage--

Mr. Sutton: --for purposes of the tenancy by the entirety.

Mr. Jones: --The marriage is the fact.

What's the fiction is that these spouses don't own anything.

Under State law they do own something.

They own something significant, as the supreme court of Michigan has said, and let me give you an example of how courts have been blinded by this fiction.

The line of cases that respondent relies on begins with the Eighth Circuit decision of the United States v. Hutcherson in 1951.

In that case, which started us down this path, the court made what are now clearly, I think, two errors under this Court's precedents.

The first error that the court made was to say that we own... that this question about what's property or a right to property is solely a question of State law.

Well, we know that what's a question of State law is what are the interests created, but whether it's property or right to property is a question of Federal law.

The Court made that clear in '56 in Bess, emphasized it again in National Bank of Commerce, and held it specifically, what, two terms ago.

Now, the other thing that Hutcherson got wrong right from the beginning was this idea that you... that the fiction of State law is controlling, and I'm... what the court said is, the interest of a tenant by the entirety in the property cannot be subject to the Federal lien because, in the words of the court, that interest is like a rainbow in the sky, or like the morning fog rising across the valley.

Well, once we get past the metaphorical fog, there is indisputably actual value at the end of this fictional rainbow.

It is... these people have pecuniary rights, the rights to receive money, and in this case the tenant had a right to receive half the proceeds of the sale, and the United States is attaching that right to receive money just like it would any other right to receive money.

Mr. Sutton: These are all contingent rights.

Would the Government attach or foreclose a piece of real estate that had been bequeathed to the taxpayer's brother and which would eventually come to the taxpayer, perhaps--

Mr. Jones: No.

Mr. Sutton: --depending upon what contingencies occurred?

Mr. Jones: And the Court made that point in Drye.

It made the difference between what is a legally protected right and what is a... what was the word you were using?

Mr. Sutton: Contingent.

Mr. Jones: No, not a contingency.

Mr. Sutton: A contingency.

Mr. Jones: It was--

Mr. Sutton: Expectancy.

Mr. Jones: --An expectancy, thank you.

An expectancy is something that is not a legally protected right.

The expectancy that was described in Drye was the hope that the will on which you're a beneficiary won't be changed before the decedent dies.

You have no right that the decedent won't change the will.

That's just an expectancy.

But once the decedent died, the right, the legally protected right that was at issue in Drye was the irrevocable right to inherit or to disclaim.

Now, once this tenancy has been created, these tenants have these vested rights.

Now, their rights may be contingent in terms of events happening in the future, but it's nothing more... nothing is more common than to say that a contingent right is a property interest.

Mr. Sutton: Well--

--Certainly the community property States, the concept of a marital community has some significance, I think.

It isn't just a rainbow in the sky.

That doesn't mean that you don't look at what rights the individual members of the community may have, but what you're saying is--

Mr. Jones: Well--

Mr. Sutton: --Go ahead.

Mr. Jones: --If I might, in a case called United States v. Mitchell, involving the community property right of a spouse to disclaim her interest in the income of her spouse, this Court said that the disclaimer, this retroactive disclaimer, this fiction of State law would not be recognized and would not upset the application of Federal tax principles.

Mr. Sutton: But it was retroactive.

Mr. Jones: It was a fiction.

Mr. Sutton: Before the disclaimer occurred there's no doubt who was entitled to the money.

She was, and this was more than a fiction.

It was undoing a property right that the State recognized until the disclaimer occurred.

Mr. Jones: Well, and indeed the State recognizes these property rights.

The State says there's significant interest in property, and it isn't silly just for me to stand here and say it's a fiction.

It is a fiction.

This Court has said it's a fiction.

In 1930--

Mr. Sutton: Mr. Jones, would you comment on one aspect of the case that troubles me?

Let's assume... I think there are two court of appeals decisions out there that are squarely on point and against you, and you say are incorrectly decided.

Mr. Jones: --Yes.

Mr. Sutton: Let's assume they are incorrectly decided, but they've been the only guidance for the tax bar for 40 or 50 years, and is there other reliance interests that the tax bar can say, well, we always thought that, given those cases that Congress had not sought to overrule, we have a right to follow them?

Mr. Jones: Well, the tax bar is not a party to this case, and... but that's--

Mr. Sutton: No, but we have to be concerned about--

Mr. Jones: --Okay, well, that's--

Mr. Sutton: --the community's reliance on decisions that have been given by the Federal courts.

Mr. Jones: --The answer... I believe the answer to your question is no, that there is no embedded reliance on this principle because, as we pointed out in our brief, even in Michigan there is an express caution given by the State bar to title examiners saying that, in light of the 1975 enactment of this statute that gives each spouse an equal right to all of the income and profits from the property, that the State bar advised title examiners that they could not give an opinion that the interest of an individual spouse was not subject to the lien.

Moreover, in 1983, I believe it was, this Court had a discussion about the status of tenancy by the entirety under the Federal lien, and the majority opinion in a footnote questioned these older cases, so I do not think that a title examiner, especially in Michigan, would be able to say that he had upset settled expectations.

Mr. Sutton: So this case involves only Michigan, and if you have States that do not provide that the... each spouse has an interest in the income, it might be a different answer.

Mr. Jones: There is, indeed, a narrow basis that you just described for resolving this case, and it would be an appropriate way to resolve the case because we have the fund... we have here the voluntary... the sale, with the proceeds available for distribution, so we don't have to reach the broader question of whether the existence of the right of survivorship, which is an undisputed personal interest, is sufficient for the lien to attach and, a la Rodgers, be subject to a foreclosure action.

It would... and--

Mr. Sutton: I must say, when you get to the survivorship, that's there I have real problems with your case.

I could just... you answered my earlier hypothetical by just saying, well, you know, there's a contingency that the will might be changed.

Well, let's assume it's not a will.

Let's assume it's an irrevocable trust, under which you have a contingent future interest.

Would you really say that the Government can move against the entire corpus of the trust just because there's a contingent future interest on the part of a defaulting taxpayer?

Mr. Jones: --The Government's lien attaches to the interests of the contingent remaindermen, and there are cases on that very point.

I am not familiar with the problem I think you're describing which is, well, can you then foreclose on the trust, and how would we value--

Mr. Sutton: Well, that's how the statute reads.

You can assert the lien on any property in which the taxpayer has an interest.

Mr. Jones: --That's correct.

Mr. Sutton: And you're saying the taxpayer has an interest--

Mr. Jones: Yes.

Mr. Sutton: --in this trust--

Mr. Jones: Yes.

Mr. Sutton: --in which he has a future contingency.

Mr. Jones: That's correct.

Mr. Sutton: I mean, that's a... I--

Mr. Jones: That's correct, but also that section 7403 reserves the right of a district court not to award foreclosure and, of course, foreclosure requires the Government to do something.

Mr. Sutton: --We hope you get a tenderhearted district judge.

I don't think that that's--

Mr. Jones: Well, the United States, so far as I know this controversy that you're concerned about has not been presented in an actual case, so I'm not sure that it's a... I mean, it's a theoretical issue that I don't believe has been confronted, but what has been confronted is, does the lien attach to contingent remainders, and that's In re... well, there's a lot of In re's.

I think it's Rosenberg's Will is the leading case on this.

We cited it in a footnote, and it explains that the Federal tax lien applies to all property and rights to property.

Mr. Sutton: --Well then, how... do you then value the contingent remainder?

Mr. Jones: Well, as I was saying, I don't know of a case where a foreclosure has been sought on a contingent remainder.

What's probably the more likely result, because it's the more economical result, is to wait for the contingency to occur, and that's--

Mr. Sutton: And the case you're talking about where a lien was asserted against the contingent remainder, what was it asserted against, after the remainder had no longer been contingent?

Mr. Jones: --I would... I'm... to be honest, I would be guessing, but my guess is--

Mr. Sutton: Okay.

I mean, that's a different question.

Mr. Jones: --Well, the--

Mr. Sutton: I want a case in which, on the basis that the taxpayer had an interest--

Mr. Jones: --Right.

Mr. Sutton: --had a purely contingent interest in some corpus.

The Federal Government was enabled to assert a lien against the entire corpus.

That seems to me extravagant.

Mr. Jones: Well, as you use the word contingency, that would include Rodgers, because that was a case where there was... a right of survivorship was the valued interest, but there's also the Bank One case, Spendthrift Trust, the right of a person to obtain income from a Spendthrift Trust is subject to the Federal lien.

Any kind of right, legally protected, valuable interest has been subjected to the Federal lien, and what the... this case reduces to is the idea that simply by, that even though they've, the State recognizes that there are valuable, legally protected interests in each spouse, that by calling it a... a something else, that the lien wouldn't apply, and that's exactly what the Court indicated in Drye shouldn't happen, that the Court indicated that the mere fact that the State doesn't characterize this valuable, legally protected right as property doesn't prevent the Federal lien from attaching.

I would like to reserve my time for rebuttal.

Mr. Sutton: Very well, Mr. Jones.

Mr. Sutton, we'll hear from you.

ORAL ARGUMENT OF JEFFREY S. SUTTON ON BEHALF OF THE RESPONDENT

Mr. Sutton: Thank you, Mr. Chief Justice, and may it please the Court:

There are some serious misunderstandings about the meaning of Michigan law which go to the heart of the proper resolution of this case under Federal law.

First of all, the Government has relied very heavily on a 1975 Michigan statute that says, spouses in a tenancy by the entirety have equal rights to rent and income and to profits.

That's section 1 of the statute that I just quoted.

If you look at page 209 of that statute in the Sixth Circuit appendix, regrettably not in your appendix, you'll see that the second section of that statute says that only applies to tenancies by the entirety created after 1975.

This tenancy was created in 1972.

That statute is utterly irrelevant.

It in all events was designed primarily just to deal with what happens when the tenancy ends, that is, when there's a divorce, just to make sure that both spouses have a right to the property.

A second misunderstanding, the Government says that the rights to proceeds, once you have proceeds as a spouse, that somehow that means the tenancy is over and the creditors, Federal, State, city, private, can get at it.

That's wrong.

Under Michigan law, Muskegon Lumber, 1953, Michigan supreme court case, says that it continues as a tenancy in the entirety.

Why?

Because most people sell their house to buy another.

You wouldn't destroy it--

Mr. Sutton: Well, we're not used to resolving questions of State law here.

If you say the State law of Michigan is one thing and the Government says the State law of Michigan is the other, it's difficult for us to go in and referee the thing.

What is the strongest Michigan case for your point of view?

Mr. Sutton: --Your Honor, 1885, Vinton v. Beamer, going forward to Sanford, going to Budwit v. Herr... those are, you know, separated by 20 or 30 years each... every single one of them makes clear that with respect to the specific belonging-to language in this statute there is no interest that belongs to one spouse or another.

They're indivisible interests.

There's a unity of title and, critically, if that unity of title is broken, Michigan law says under Budwit v. Herr, a Michigan supreme court decision, the tenancy is destroyed.

Mr. Sutton: And you say the 1975 statute does not affect this case at all?

Mr. Sutton: It's irrelevant, Your Honor.

By its terms it only applies to tenancies that are created after 1975.

That's section 2.

It's in the act.

That's not legislative history.

That's in the act.

Mr. Sutton: Mr. Sutton, how does it differ from other cases where under State law a predator can't touch the thing, like a Spendthrift Trust, or like what was involved in Drye?

Even though not a single predator in that State could touch that inheritance, the Federal taxing authorities could, so there are many situations where the property is exempt from reach, even where the State doesn't call it property, calls it something else, but the elements of what the person had leads the Federal authorities to say this is the property of so-and-so, as in the Spendthrift Trust, as in the case of the disclaiming heir in Drye, so why is this any different?

Mr. Sutton: This is not a disclaimer or exemption case for this basic reason.

We're not relying on the results under Michigan law.

We're relying on the rationale under Michigan law for the exemption.

The rationale under Michigan law is that neither spouse owns an independent interest in any respect.

Not even the survivorship right under Sanford is considered an independent interest.

Mr. Sutton: Why was that different from a State law that said Mr. Drye never had anything, we assume under our State's law that he predeceased his mother?

Mr. Sutton: Your Honor, under Arkansas law in Drye, the opinion notes that he did have a right to alienate that interest once his wife died.

That's exactly what... that was the point of the decision.

For 9 months, he had a right of control over the property and it may be helpful... I want to make sure I'm answering your question... to think about these interests in present terms and future terms, and if you talk about present interest, I think the way Drye talks about it is, you have to have a present interest of pecuniary value over which the taxpayer has exclusive dominion.

That is not true in a tenancy by the entirety.

The closest you can come to finding something over which the individual taxpayer might have dominion of control are the future interests, the right to proceeds, the right... survivorship rights if you outlive your spouse.

Mr. Sutton: Could the Congress with ease enact a statutory amendment to make tenants by the entirety subject to liens?

Mr. Sutton: Absolutely, Your Honor.

I would submit that that's one of the strongest points supporting Mrs. Craft's position.

For 136 years--

Mr. Sutton: Well, I mean, if you were a Senator from Michigan wouldn't you say, well, you're taxing property that doesn't belong to the taxpayer, this is improper as a matter of law?

Mr. Sutton: --That's exactly what Tyler recognized, the 1936 or so U.S. Supreme Court decision that yes, these are fictions under State law but, under the Supremacy Clause, the Federal Government is entitled to disregard them if it wishes and, notably in the estate tax setting, that's an estate tax case, the Court... in that law, Congress specifically said tenancies by the entirety are covered by the estate tax.

Indeed, page 502 of Tyler says, but for the specification of tenancies by the entirety by terms, the estate tax would not cover those interests.

Mr. Sutton: Well, our--

Mr. Sutton: That's our case.

That's this case.

Mr. Sutton: --Our universe here is that the State defines what's property and the Federal Government defines what property can be liened.

Mr. Sutton: Yes, Your Honor.

Mr. Sutton: That doesn't quite work, because one of the sticks in the property definition is the right to be liened, and so we're compromising that dichotomy even by stating it, and it seems to me that all the Government is doing here is saying, we're saying what property can be liened, we're entitled to define that one stick in the bundle.

Mr. Sutton: I'm not relying, Your Honor, on what's lienable and what's not.

Well, I am in terms of the common law background.

That's highly relevant that in 1866 no one would have thought this was a lienable property interest, but when it comes to the present Michigan law, I'm not relying on whether it's lienable under Michigan law.

I'm relying on why that's true, the rationale for why it's not lienable.

You can't lien... maybe this is the better way to put it.

You can't lien an innocent property owner's property.

If everything they're saying is true about this somehow belonging to Don Craft, it is most assuredly also true that it belonged to Sandy Craft, and Justice Ginsburg, she did file her tax returns, independent tax returns.

She paid her taxes, and there's no more right for the Federal Government to put that lien on your property or mine, that it was--

Mr. Sutton: Well, but if you're right about that, Mr. Sutton, then your statement that Congress could easily amend the statute to collect in this situation probably isn't correct.

Mr. Sutton: --Well, Your Honor, I did not mean to say... I did say easily, and I misspoke, and I'm glad to have an opportunity to correct.

I think it would be very difficult, because of the fact that under Michigan law the property ownership interest might create a situation where the minute you foreclosed, great, you got $100,000 for Don's interest in the property.

Every dollar they took belongs to Sandy, so it's... it is a difficult area to regulate.

It would be a... and... but that's again exactly why, in gift tax, estate tax, fair debt collection... that's the Federal fraudulent conveyance law, bankruptcy, every one of these areas not only mentions the tenancy specifically, but it then goes on to do what Justice Kennedy and Mr. Chief Justice Rehnquist's questions indicate.

You've got to be very specific about how in the world you value these interests, and what you decide to do once you've decided to regulate them.

Mr. Sutton: Mr. Sutton, is it true that any conventional property interest in Michigan can be held in the entirety form?

Mr. Sutton: No, Your Honor.

Personal property... it does not apply to personal property.

The only exceptions are proceeds from real estate, the example I gave when you sell the house.

Mr. Sutton: Does--

--What about... bank accounts can't be--

Mr. Sutton: No, Your Honor.

Mr. Sutton: --And shares can't be--

Mr. Sutton: No, Your Honor.

No.

Mr. Sutton: --What about the income from the real estate?

Is it your position that before this statute was passed even the income from the real estate was held--

Mr. Sutton: Absolutely, and that's--

Mr. Sutton: --in tenancy by the entirety?

Mr. Sutton: --Let me give you... S&B Trust, it's one of the cases we've cited, says that very point, and that makes sense.

It's still property that they... it came from their joint marital asset, and they use it together.

I want to go--

Mr. Sutton: How does it differ from community property?

Mr. Sutton: --Community property has several differences.

It's much more like a joint tenancy.

First of all, you can petition, which incidentally is exactly what the effect of this statute is, to by law petition their interests.

Secondly, you have shares in the property, and this is exactly like Rodgers and National Bank of Commerce.

There were divisible shares that could be levied.

Mr. Sutton: I thought the community property is owned by the community, which is a separate entity.

Mr. Sutton: No, Your Honor.

Mr. Sutton: Community property is not owned by a community which is a separate entity?

Mr. Sutton: No.

It really works a lot like the homestead.

I want to be clear here.

It's true that the... in one sense the home in a community property State or a homestead State is still one where they both have interests as to all the property, so in that respect you're right, they still have joint interests.

But the critical legal distinction respecting the 19th Century all the way to this century is that in one setting you had divisible shares, and that's why one spouse in a home State setting, community property setting, could unilaterally incumber or destroy the tenancy.

Mr. Sutton: I'm not sure you can generalize as to community property.

I think the law varied in... among... between the community property States.

Some would say one thing, some would say the other.

Mr. Sutton: Your Honor, you're right, and if I--

Mr. Sutton: The hornbook that we looked up just says that community property can be severed only with the consent of both spouses in the event of divorce, or in the event of death of one of the spouses.

It's a book called Real Property, by Bernhardt and Burkhardt.

Mr. Sutton: --Well--

Mr. Sutton: Again, I don't know that that's authoritative, or maybe we made a mistake, but it certainly was my impression that community property is owned by a community, which is a different legal entity, and I also thought that community property couldn't be separate without the consent of the spouse.

Mr. Sutton: --Well, that... Your Honor--

Mr. Sutton: Is that wrong?

Mr. Sutton: --if... let's assume for the sake of argument, and I'm not... let's assume it's true, you said it's true, that community property States are just like tenancy-in-the-entirety States.

That's fine by us.

Mr. Sutton: Well, I know, but all it means is--

Mr. Sutton: The exact same argument applies.

Mr. Sutton: --that if you're right, that in probably a third or more of the country, suddenly the IRS can't assert any liens, and it's a little tough to believe that Congress would have thought that that's what it was doing with this statute.

Mr. Sutton: Oh, Your Honor, I respectfully disagree.

In the very... the backyard of Congress they are saying tenancies by the entirety are exempt.

I mean, in the District of Columbia, which Congress has sovereign prerogatives over, they've said from the beginning that we favor these marital community property interests over those of creditors.

Mr. Sutton: Mr. Sutton--

--Yes, that may be, but why... I mean, here, a lot of property in this country is owned by communities, i.e., the husband and wife together, and I imagine that people are quite free to take their real property in the form of tenancy by the entirety.

All right, now here the property interest is definite.

There's no doubt that the husband is entitled to a lot of money, and there's nothing imprecise about it, nor is there really anything speculative about it, unless you go and divide it into a present and future.

All those divisions you've made are purely legal ways of looking at what in reality is an absolutely precise and valuable property interest owned by the husband.

All right, now why should I accept an interpretation that's going to exempt vast amounts of property from this statute--

Mr. Sutton: A couple of thoughts, Your Honor.

Mr. Sutton: --under those circumstances?

Mr. Sutton: This is not a community property case, and I think it would be dangerous for me to--

Mr. Sutton: But I'd like to know what the implications are--

Mr. Sutton: --If--

Mr. Sutton: --because it's one thing if we're deciding a case... yes.

Mr. Sutton: --If you find, in each of the States that you're concerned about, the interests are defined just as they are in Michigan, which is to say, it's an indivisible interest, no shares, it follows just from what you've said in Rodgers and National Bank of Commerce that you can't lien the property, and what you've got to do is wait for a survivorship interest, wait for a sale, destruction of the tenancy.

But if there's a problem here, Your Honor, Congress has known about it.

This has been true for 136 years.

Mr. Sutton: Mr. Sutton, how many States are there that have tenancies by the entireties?

Mr. Sutton: 14 that have them in the traditional way we're talking about, where it's an indivisibility of title, plus the District of Columbia.

Mr. Sutton: And some of them, at least according to a case that both of you cited, do provide tenancy.

Tenancies by the entirety can hold business assets, personal property, even money may be held in some States, so if your theory holds, then a couple could insulate everything that they have simply by holding it all--

Mr. Sutton: Well, to the extent Congress is worried about that, it's surprising in 1954 that they didn't amend the statutes, even more surprising--

Mr. Sutton: --Well, didn't this Court comment on that in the Rodgers decision by saying that the fact that Congress didn't do something... you can't infer much from not doing, according to this Court.

Maybe the Senate rejected the clarification that the House sought, not because it disagreed with it, but more likely because it found it superfluous.

Mr. Sutton: --The 1954 history is relevant, I would think all would agree, when it comes to the notion that somehow this is a great tax-avoidance problem.

Congress at a minimum was told about this issue and decided not specifically to do anything about it.

Whether the law was changed or not--

Mr. Sutton: And this Court commented on it, that maybe Congress didn't do anything because it thought that the... this--

Mr. Sutton: --Your Honor, by 1966... I mean... well, by the present, we've got seven courts of appeals.

Every court of appeal that's looked at the issue has said the tax lien does not apply when just one spouse has a tax debt.

In 1990, critically--

Mr. Sutton: --In this particular case, wasn't the Sixth Circuit saying, well, maybe there are good arguments on both sides, but we've got that old precedent that we have to follow.

Wasn't that the background of this case?

Mr. Sutton: --I'm not sure what the Sixth Circuit had in mind, but it certainly followed its precedent, didn't think Drye, Irvine had changed the law necessarily--

Mr. Sutton: Well, it couldn't have thought about Drye the first time around, because Drye wasn't there.

Mr. Sutton: --No, but the second time it did.

Mr. Sutton: They had already made the decision.

Then there was a big discussion about law of the case and law of the circuit, so I don't think that they ever had this case with Drye squarely in front of them, because they decided the basic case without Drye and later they were relying on law of the case, law--

Mr. Sutton: Well, I certainly don't know why each court of appeals has done what it did, including the Sixth Circuit, but the fact is, they've all done the same thing.

I think it's also notable to the extent there's a tax avoidance concern lurking here, why is it in 1990, when Congress passed the Fair Debt Collection Act... that's the Federal fraudulent conveyance statute... why did it specifically exempt tenancy by the entirety property?

Under that law today you could do exactly what happened in this case and the Federal Government would have nothing to say about it.

Mr. Sutton: --I suppose, if you follow the... your rationale to its furthest extent in a State such as the one Justice Ginsburg referred to in which business assets can be held in tenancy by the entirety, a husband and wife could hold a... have a closely held corporation by the entirety and, on your theory, they wouldn't even be liable for income tax because it would be the entirety alone that would be liable.

Is that the--

Mr. Sutton: No.

No, Your Honor.

Mr. Sutton: --fair consequence of what you're saying?

Mr. Sutton: Under section 61, which is the provision of the Internal Revenue Code that taxes property, income from tenancy by the entirety property is still taxed.

It's never been a--

Mr. Sutton: No, but the income goes into a bank account held by the... held in entirety form.

If they're careful enough, so that they set up their corporation, their savings account, their checking account, everything's held in entirety form, there wouldn't be any individual taxpayers under your theory.

Mr. Sutton: --Well, I'm not going to be in a position to cite any cases for this point, the point that I'm going to make, so you're going to want to check me on it, but I don't think there's any doubt that when it comes to income from tenancies-by-the-entirety property, the case law, the code, the regulations make it clear that they're still... you're still taxable.

It's just a question of--

Mr. Sutton: Well, I don't think there's any doubt, either, but I think the fact that there isn't any serious doubt about it is, at least so far as the States that Justice Ginsburg's example referred to, there also is an inconsistency between the fact that we have no doubt, as you say, about taxability and the consequences of your theory.

Mr. Sutton: --Well, it's a... they're very different concepts and maybe it's important, particularly in light of Justice Breyer's comment about this just seeming to be a fiction, there's a real function behind this concept, and the function is that, while the tenancy is premised on this nice notion of two hearts beating as one, the fact is that doesn't always happen, and the whole point of the tenancy and the indivisibility of title is that it precludes one spouse unilaterally from destroying or otherwise incumbering the tenancy.

Keep in mind, that's exactly what happened in this case.

Mr. Sutton: Well, but the--

--Then in your mind the critical factor is the factor that creditors under State law can't get a hold of it.

Mr. Sutton: No, Your Honor.

If it's indivisibly owned, that means that every lien on Don's interest was a lien on Sandy's interest, and Sandy paid her taxes.

If there's one first principle of lien law, it's that--

Mr. Sutton: Okay.

Then you're saying it's the theory of the thing.

Mr. Sutton: --It's--

Mr. Sutton: Okay.

If it's the theory of the thing--

Mr. Sutton: --It's a theory that has a fact--

Mr. Sutton: --If it's the theory of the thing, primarily, plus the fact... all right.

If it's the theory of it, why--

--Go ahead.

If it's the theory of it, doesn't the same theory exist with community property?

Doesn't the same theory exist with joint tenancies?

For all I know, the same theory exists when people said, you don't own any land, you just hold it from the king, and you have feudal obligations unless you pass along the seasons.

I mean, that's... if we're going on the theory of the thing--

Mr. Sutton: --I really hope I can clarify this because I do think it cuts the heart of this case.

Most States that don't have tenancies by the entirety do have joint tenancy, so that really is the key comparison, and as to those States, when you have a joint tenancy, first of all they are divisible interests.

If they're divisible interests, that means one spouse unilaterally can incumber and in some instances sell that right, whether it's a future right, the right of survivorship, or a present right with respect to some interest in the property, so that's the whole point.

The whole point is, in those States people have decided to marry, buy property together, but yet from the beginning one spouse unilaterally could destroy or incumber the property.

In a tenancy by the entirety, at the outset, every decision you make regarding that property has to be made with the consent of your spouse.

Mr. Sutton: --Well, is the question of taxability at bottom a question of Federal law, do you suppose?

Mr. Sutton: I would submit, Your Honor, that when it comes to the tax lien statute the Court has said several times that Congress did not define the words, property, rights to property belonging to.

We look first to State law--

Mr. Sutton: But is it a question of Federal law, and as a policy matter we generally look to State law?

But isn't that itself a question of Federal law, the extent to which we're going to look to State law?

Mr. Sutton: --Well, Your Honor, I had thought that you take the State law's property interests as you find them in the 50 or 51 jurisdictions, depending on how you want to look at it, and then, depending how the States--

Mr. Sutton: But for tax purposes, I'm just wondering if at bottom it isn't, in fact, a question of Federal law.

Mr. Sutton: --It is a question of Federal law what the, quote, consequences of those State law definitions are, but let me give you, I think, a good indication of this, and it relates to a hard issue raised by Justice Ginsburg.

What about tenancy by the entirety where it was a joint bank account, which is clearly a much harder case, not presented here.

Here, we're talking about the marital home.

But in National Bank of Rodgers, which was about a joint tenancy, the Court said in a 5-4 decision that you could levy on one person's joint bank account.

Why was that?

Because under State law, the taxpayer, or he had a right to all of the money in the account unilaterally, whenever he wanted it, and if he misused it, that was simply to be a fight among the other joint tenants.

Justice Blackmun in writing that decision made it crystal clear that that case turned on the fact that under State law the taxpayer had a unilateral right to take all the proceeds.

If that State law had said differently, that the only way you can take out the proceeds is with the consent of the spouse, there's--

Mr. Sutton: Which case are we talking about now?

Mr. Sutton: --National Bank of Commerce, 1985, joint bank account.

If that State law had said, the only way you can take out the money in the bank account is with the consent of the other, the Court, by the terms of its decision, would not have allowed that levy, and remember, the levy and lien statutes have the exact same language, which, you know, in order to lien something you've got to be able to levy it, generally speaking.

So I don't... that proves to me... I hope this answers your question, Justice O'Connor... that these definitions of State law do matter.

They are controlling when it comes to the consequences, and I hope I've showed, when it comes to--

Mr. Sutton: Mr. Sutton, I think that there was considerable attention in the Drye case to exactly what it was you look to State law for.

You look to State law to find out what the person had.

Whether that was characterized as property or not was a Federal law question, and Drye could not have been clearer that you look to see what sticks the State law gives.

Mr. Sutton: --But Your Honor, what have I said that makes you think I'm disagreeing with that?

Mr. Sutton: Well, I thought you said that whether it's property is determined by State law.

Mr. Sutton: I'm simply saying the interests in the property are determined by State law.

Mr. Sutton: What the taxpayer had is determined by State law.

Mr. Sutton: Exactly.

Mr. Sutton: But not the label that we put on it.

Mr. Sutton: Absolutely.

Mr. Sutton: For Federal tax purposes.

Mr. Sutton: Absolutely, and I'm sorry if I left that ambiguous.

I mean, let's talk about this in terms of the classic--

Mr. Sutton: Your point there is right there.

Your point is, I take it, that in this case State law defines the property such that it belongs to both parties and, indeed, it is not possible under State law without the death, divorce, or consent of one of the parties for anyone to get a hold of a penny of the... of that interest.

Mr. Sutton: --Absolutely, Your Honor.

Mr. Sutton: That's your point--

Mr. Sutton: To use the sticks--

Mr. Sutton: --that both of those things have to be true, the theory and the practice.

Mr. Sutton: --Yes.

Mr. Sutton: All right.

Mr. Sutton: To use the sticks in the bundle analogy, every interest under State law in Michigan regarding this tenancy, each stick has to be exercised two by two, not one by one, but every one of them is two by two, husband and wife, and certainly not three by three, which is what the Federal Government is saying here.

Mr. Sutton: But it is for the Federal Government to determine to what property the lien extends.

Mr. Sutton: I couldn't agree more, Your Honor.

I mean, not... I wouldn't say the executive branch.

I mean, in the 1971 Benson decision they admitted that the lien does not cover tenancy by the entirety.

If you look at that 1971 decision, they admitted in that case it doesn't cover it, so this is not an administrative deference situation at all, but the Federal Government, through Congress and the President, does have a right to extend it.

I will admit, it's not going to be easy, and if we could go back to thinking about--

Mr. Sutton: Their point to the contrary is basically, you're right, or assuming you're right, it's still definite enough to get at, and you really violate State law policy there only if you sell the property, you see, but as long as... and, indeed, if they sell it on their own, that's their problem.

You'll get the proceeds.

If they don't sell it on their own, you know, the community... if they don't sell it on their own, then it becomes a question of how the judge will enforce the lien, and there your clients or the equivalent would be free to go in and say, don't force me to sell the property, et cetera.

Mr. Sutton: --I hope I'm responding to your question.

I think what I hear you saying is that boy, this is just a lien, they're just placeholders, it doesn't mean they'll necessarily foreclose, and therefore Sandy's interests really aren't being hurt.

I would submit that's wrong.

Sandy Craft--

Mr. Sutton: You say Sandy.

She's noted as the respondent as Sandra.

Mr. Sutton: --Excuse me, Your Honor.

I'll say Mrs. Craft, to be even more careful.

Excuse me.

But in this particular case, the lien does have an impact on their ability collectively to make decisions about the property.

Let's say the month after the lien attached, they decided, we need to borrow against the house to have enough money to pay for our kids' college education, because the roof has collapsed.

They can't do that.

Prior to the lien, she had a right to make a decision not with the Federal Government about how to use this property, but with her husband, and a classic tenet of lien law is you get no more lien rights than the debtor had, and you've got a situation here where they're 1) trying to act as a spouse, but 2) dictating how this property ought to be used, when that was a decision that under Michigan law only the two spouses could make together.

I want to go back to a point that I went over a little bit too quickly.

The consequence--

Mr. Sutton: I'd just like to ask you one question about Michigan law in origin, because you said this goes back to 1866, so it was probably before the Married Women's Property Act, so... at least in some States it was, so whatever rights there were to control and make decisions, they were all in the husband at that time.

Mr. Sutton: --Most of the Married Women's Property Acts, almost all of them were passed before 1866, so first of all that defect, I would call it, in the old tenancy simply was no longer true, and even in some States where that continued, it was still this, I guess it's jure uxoris concept, that it wasn't the husband as an individual having an opportunity to do this, it was the husband acting on behalf of the wife, but that just isn't true under Michigan law.

They still have these equal interests in the property, as proved by the fact of what happens on a divorce.

The point I glossed over and I wanted to make sure was understood, the issue here is not just whether the lien attaches to the tenancy, I would submit that under Michigan law, if a lien does attach, it destroys the tenancy, so we have a situation where a unilateral act of one spouse has destroyed the tenancy by operation of law under Michigan.

It becomes a tenancy in common that destroys the right of survivorship, and that also means because there are now divisible interests in the property that one spouse, unilaterally again, can incumber the property and expose the marital home to these debts of just one spouse, so this is not just a modest question then.

Mr. Sutton: But--

--I thought, Mr. Sutton, this is a question of what the Federal taxing authority can do.

Everything that you've been speaking about is something that Michigan can say, no creditor of these people--

Mr. Sutton: Your Honor, I agree with you, Michigan could change the law, though I think at that point the rationale and the effect would line up.

Mr. Sutton: --I don't think there's any question that Michigan law, just as Arkansas law, continues to say, creditors, you can't get at this disclaimed property, same thing Michigan can say.

The only thing that Michigan can't control if this decision should go the other way is what the Federal taxing authorities can do, not one thing about any other creditor under Michigan law.

Mr. Sutton: The problem for people like the Crafts is that they've already said it.

In Budwit v. Herr they say, the minute you destroy the unity of ownership you destroy the tenancy, so I--

Mr. Sutton: Isn't the concern that the tenancy not be destroyed, in effect as a result of a consensual act by one of the spouses, an alienation by a spouse alone--

Mr. Sutton: --The nonconsensual act, right.

Mr. Sutton: --the incurring of debt by one spouse alone as a consensual act, i.e., going on a spending spree?

But here, the consensual act of the spouse has nothing to do with it.

It's not a consensual act of the spouse that the spouse has to pay income act--

Mr. Sutton: Oh, but Your Honor, it is.

Mr. Sutton: --and therefore it seems to me outside the rationale that you're proposing for the tenancy.

Mr. Sutton: I respectfully disagree, Your Honor.

It's exactly the rationale.

There's no difference from Mr. Craft unilaterally trying to incumber the property with his own loan, using the property as a mortgage to back it up.

Mr. Sutton: Sure it is.

He goes out and says, I want a loan to buy a Cadillac.

That's certainly a fair concern of the State in protecting the wife.

That concern doesn't extend to a situation in which the tax law of the United States says, you're going to pay tax on your income whether you like it or not.

Mr. Sutton: But Your Honor, it's a unilateral act, number 1, by the spouse, and number 2, it is a lot like a loan.

Mr. Sutton: What's a unilateral act, earning the money?

Mr. Sutton: It is a lot like a loan, Your Honor.

If you need $50,000 a month to support some bad habit, you can get it by borrowing from a bank or not paying your taxes.

It has the exact same effect when it comes to the unilateral conduct of one spouse undermining the marital property.

But again--

Mr. Sutton: And then, if Congress said this explicitly, the same thing would follow, everything that you said.

Congress would then be destroying--

Mr. Sutton: --They could do what they did in the estate tax, which is regulate it specifically.

I would submit, it is not an easy process.

Mr. Sutton: --I thought that the... oh.

Mr. Sutton: Why doesn't Mrs. Craft have a takings argument the minute this lien attaches for the entire value of her property?

Why is that not the case?

It's not obvious to me.

Mr. Sutton: Just as Mr. Drye didn't when his State law said--

Mr. Sutton: But there was only one taxpayer in Drye.

You didn't allow a lien... excuse me.

Mr. Sutton: --Thank you, Mr. Sutton.

Mr. Sutton: Thank you, Your Honor.

Mr. Sutton: Mr. Jones, you have 3 minutes remaining.

REBUTTAL ARGUMENT OF KENT L. JONES ON BEHALF OF THE PETITIONER

Mr. Jones: Thank you.

I have only a couple of points.

The first one is that the tenancy involved in this case was destroyed when it was transferred from the husband to the spouse.

That's one.

That's the first instance when it was destroyed, and secondly it was destroyed when the wife then sold it to a third party.

What we have are proceeds that are not subject to a tenancy by the entirety.

We have proceeds that are... to which the former tenants are each entitled to 50 percent.

The right, their right to have 50 percent of the proceeds is confirmed by 577.71 of the Michigan Code, which was enacted in 1975, but it preexisted that as we pointed out in the cases that we've cited in our reply brief.

I will say that the suggestion that this statute that gives each spouse an equal right in the property only applies to tenancies created after 1975 is a new contention.

It's not addressed in the briefs.

It catches us by surprise, but I will point out that the Dow case--

Mr. Sutton: It shouldn't be a surprise if it's in the statute you're quoting to us.

Mr. Jones: --What I will... what is in the statute that I--

Mr. Sutton: Is it in the statute?

Mr. Jones: --What I have in my possession is a copy that says that the effective date is 1975, and I do know that in Dow v. State, decided by the supreme court of Michigan in 1976, they applied that statute to a tenancy that had been created prior to 1965.

This statute that was enacted in 1975 reflects a policy of, I suspect, every State in the modern era to recognize the equal rights of the spouses and the tenants in the property, and not to respect--

Mr. Sutton: Suppose it didn't.

I mean, is it your... are you conceding, then, that the Government cannot assert a lien on a real tenancy by the entirety?

Mr. Jones: --No, not at all.

I'm saying that we have such a lien in this case, both from the right of survivorship, if we ever had to get there, but more importantly because we have a lien in the right to receive proceeds.

This statute that was enacted in '75 does not directly address the proceeds issue.

The proceeds right preexisted the statute.

What the statute addressed was the equal right to income during the existence of the tenancy by the entirety, and the equal right to control the management.

Mr. Sutton: Mr. Jones, can I ask you one question?

I hate to take up your reply time.

In your view, will the decision in this case control in community property States, raising the same question?

Mr. Jones: Well, I think the principles that you apply will, of course, control, and--

Mr. Sutton: Yes, but--

Mr. Jones: --And whether a decision in this case addressed principles that would extend or apply in that situation as well as this, I can't say.

I--

Mr. Sutton: --Can... do they... in a community property State, can one spouse force division over... to an unwilling spouse?

Mr. Jones: --Under State law there are limitations, but those State law limitations have already been held to be ineffective against Federal tax provisions.

Mr. Sutton: But the community property is subject to the debts incurred during the marriage?

Mr. Jones: That's correct and, again, in the Mitchell case the Court held that State law fictions about the relative rights in community property States are no more binding on the Federal tax collector than in other contexts.

Chief Justice Rehnquist: Thank you, Mr. Jones.

The case is submitted.

Attribution:

The OYEZ Project

Featured:

United Dominion Industries v. United States - Oral Argument

Fri, 09 Jan 2009 14:50:35 +0000

Case:

United Dominion Industries v. United States

Media File:

00-157_20010326-argument.mp3

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transcript.xml

Transcript:

Argument of Eric R. Fox

Chief Justice Rehnquist: We'll hear argument now in Nunber 00-157, United Dominion Industries, Inc. v. United States.

Mr. Fox.

Mr. Fox: Mr. Chief Justice, and may it please the Court--

There is a single element in this case that properly determines its outcome, and that is that the product liability loss, as the district court said, and you can find this on page 36A of Appendix B. The product liability loss is a subset of the net operating loss.

Section 172(a) and 172(b)(1)(A) of the Internal Revenue Code provides that a net operating loss can be carried back three years.

Section 172(b)(1)(I), and you can find the exact language on page two of petitioner's brief, provides that in the case of a taxpayer which has a product liability loss, the product liability loss shall be a net operating loss carry back to each of the ten taxable years preceding the loss year.

In Section 172(j)(1) then defines the term product liability loss, and that is, it is the lesser of the net operating loss for the year, and that is the net operating loss that can otherwise be carried back three years, or the sum of the amounts allowable as product liability deductions.

So it is clear that the product liability loss is nothing other than a piece of the net operating loss.

And if you apply that rule to a single stand alone corporation, the first thing you do is determine whether the corporation has a net operating loss.

If it has a net operating loss, the next thing you do is determine the extent to which that net operating loss is attributable to product liability deductions.

And the product liability deductions in an amount not exceeding the net operating loss then becomes the product liability loss.

That can be carried back ten years, but it's all part of the net operating loss.

So if you have a product liability loss that's less than the entire net operating loss, then after you carry back the product liability loss ten years, what is left of the net operating loss can be carried back three years.

The important part--

Justice Kennedy: Is the theory of the statute that development of these products usually takes longer than a three year period, and that what we're just trying to do is allow the company to have its loss carry back apply to those years in which it was engaging in research?

Is that the theory of the statute, or is there some other theory?

Mr. Fox: --I think the legislative history suggests that there was some concern that product liability suits and the like took time to arise, and that a product might be sold in a particular year, generate income, and then it wouldn't be for many years before the product liability suit arose.

And in order to provide a longer period of income against which potentially large losses might be deducted, the Congress thought it was appropriate to extend the statute and allow going back as far as ten years.

I think the theory was that it would be logical that the income might arise years earlier than the three year period, and Congress was simply extending the carry back period to allow for that problem.

Justice Kennedy: I suppose it doesn't help us much because if I told you, well, that makes it sound very corporation specific, you would say, well, so are all other net operating losses when they're calculated.

In the first instance, they're specific to that corporation, and yet they are carried over to affiliated groups, so product liability losses should be given the same treatment.

I take it that's your argument.

Mr. Fox: Well--

Justice Kennedy: You want to make it a better argument, huh?

Mr. Fox: --Well, I'll try, Justice Kennedy, if I can.

I believe that the plain language of the statute when applied to an affiliated group of corporations requires the outcome that we seek.

Justice Souter: Would you respond, Mr. Fox, to the claim that what you're arguing for is a double deduction, and would you tell me in the first instance something that maybe I should have gotten from the briefs, but I just couldn't find it.

Did the... did the successful companies in this affiliated group which, in fact, as I understand it, had the expenses involved here... did they deduct the product liability expenses in the course of calculating what in effect turned out to be positive income which was then attributed to the group?

Had they already... leaving aside the treatment... the possible treatment of the loss, has there already been a deduction taken by the constituent companies here?

Mr. Fox: No.

Justice Souter, I want to make perfectly clear there is absolutely no double deduction in this case, and there was no deduction in computing separate taxable income in the sense that a tax benefit was produced at that point.

There was clearly a subtraction of the product liability deduction in arriving at separate taxable income.

That is--

Justice Souter: Well, then--

Mr. Fox: --incontrovertible.

Justice Souter: --why aren't you asking for that same subtraction, as it were, to have the further benefit for the affiliated group?

Mr. Fox: The reason is that when you... when a single corporation or an affiliated group has a net operating loss, the total amount of that loss has not produced any tax benefit because you have had deductions that exceed income, and, yes, you've deducted them in the sense that you subtracted them, but now you come up with a negative number, and that negative number, which is all we're talking about here... the net operating loss... that in and of itself does not produce a tax benefit.

It's just... it's hanging out there until you can carry that negative number to some other year and take a deduction against income in that other year.

Then the deduction produces a tax benefit, so we have--

Justice Scalia: What we're arguing about here is whether you go back three years or ten years.

Mr. Fox: --Exactly, Justice Scalia.

That's the only thing we're talking about.

The fact is that the very same product liability deductions that have been, quote, deducted, in arriving at separate taxable income are in the net operating loss that Respondent will agree we can carry back three years.

And if we can carry it back three years and take a deduction, there's no double deduction.

They would not claim that.

They now want to say that because we're going back ten years, there's a double deduction, but that's simply not the case because we're reducing what we can otherwise take back three years.

Justice Ginsburg: Mr. Fox--

Mr. Fox: All we're doing is--

Justice Ginsburg: --I understand that there's no dispute at all about the amount involved.

As you said, it's just a question of whether it's a three year carry back or a ten year carry back.

But there's one feature of your case that's different from the Intermet case... the other side of this split... and that in Intermet, the corporation had sustained the loss that Lynchburg was also a member of the consolidated group in the carry back year.

But as I understand the facts of your case, you... the deductions of the losses sustained in '83 to '86, and you want to carry it back to '73?

Years when the corporations had sustained the loss were not part of the affiliated group.

Why should it be carried back... why should the affiliated group get this benefit when the companies who sustained the loss were not part of it in those carry back years?

Mr. Fox: --The regulations have a mechanism for dealing with corporations that join a group and provide that in the case of a net operating loss, if a member of the group contributes to the net operating loss by itself having a loss, and in the carry back year, be it three years or ten years earlier, it was not a member of the group, a portion of the overall net operating loss can be allocated to that company and carried to a separate return year outside of the consolidated return.

In this case--

Justice Scalia: Can be or must be?

Mr. Fox: --Must be.

In this case there... the corporations that generated... the members of the group that generated the product liability deductions would not have an allocated net operating loss under that provision of the regulations which is 79.

And so there is no mechanism for carrying back to any separate return year.

The only carry back can be within the group.

Now, if you have a corporation that joins a group and has deductions, even though it just joined the group, any deductions it has are going to find its way into the net operating loss that can be carried back.

So the question again is the fact that the corporation would have deductions, even though it had separate taxable income.

The fact that it is contributing to the net operating loss, even though it wasn't a member, say, the last year, does not prevent its deductions from being carried back three years as part of the net operating loss.

And so in this case, it's merely a fact that they're going to be carried back ten years instead of three years.

Justice Scalia: You say the same problem exists under the three year carry back?

Mr. Fox: Exactly, because any deductions that this corporation has for product liability are going to find their way into the net operating loss that can be carried back three years, and that would be before it was a member of the group.

Justice Breyer: Is this right... and tell me, if it's wrong, I'm not going to pursue it... but it seems to me the theory of this thing is that we have a company called Company A, and Company A has, let's say, a loss of two dollars over the year.

And what this statute normally says is wait... Company A, if you have some product liability loss, there are a lot of things that can cause losses, and you have all of them.

It was a terrible company.

But we're going to pretend that the two dollars there is product liability loss.

That's called, let's pretend that's what the statute says... as long as there was two dollars of it.

We're not going to call it some other loss.

Now, what you want to do is if Company A is part of, let's say, fifteen other companies, you want to pretend that the big losses run by these other companies which had nothing to do with product liability are product liability losses, too.

Mr. Fox: Well, I would agree with you, but I think--

Justice Breyer: Is that what you... that's what you're reading in the statute--

Mr. Fox: --Yes.

Justice Breyer: --All right.

Now, if that's so, then there's a great thing we could do.

We have some big losses in our company, so we look around for some other firms that happen to have some product liability losses, but they're just marginally profitable.

Now we buy them up, and now our let's pretend game allows us to count as our losses which came from totally other things... having a very bad product, for example... now are product liability losses, so we get to go back ten years.

Now, that would be a consequence of accepting your position, is that right?

Mr. Fox: Theoretically, yes, Justice Breyer, but I think that is a... that the example which comes from the Respondent's brief is a very far fetched example.

Number one, it is highly unlikely to arise.

You have to go out and find a coincidence of facts that fit just perfectly, number one.

Number two is that the result that you have just posited is not something that flows from the consolidated return regulations, but it is a result that can exist if a single stand alone corporation were to find itself in the same position, it could go out, buy another corporation if the facts fit perfectly, liquidate it, and do exactly the same thing.

Justice Breyer: Okay.

Justice Scalia: But for that matter, it would apply within the three year period if it's just seeking a three year carry back, no?

Although I guess it wouldn't matter if it's product liability carry back or not.

But that can happen under the three year carry back, can't it?

Mr. Fox: Well--

Justice Scalia: Can't you purchase somebody with losses that will enable you to carry back what you otherwise wouldn't be able to carry back three years?

Mr. Fox: --That may not--

Justice Stevens: No, but then you're purchasing somebody with profits in Justice Breyer's example.

Mr. Fox: --Might not work that way because if, first of all, if they were separately profitable, then they wouldn't be contributing any losses.

Of course, if they had losses, then they'd have to carry them back to a separate return year of their own.

That's why I find that this hypothetical requires coincidences that are very unlikely to exist.

Justice O'Connor: Does Treasury Regulation 79(a) bear on the extent to which Justice Breyer's example could be calculated?

Mr. Fox: Not really, not really.

Not the example that is in Respondent's brief.

It wouldn't affect that.

Justice O'Connor: To what extent do we owe deference to the Government's position in this case?

Mr. Fox: I would say you owe no deference whatsoever.

First of all, I noticed as I was walking into the building today there was a quotation from Marbury v. Madison etched into the wall that said that it is this Court's obligation to decide what the law is.

But moreover, there really is not a Treasury position here.

There's no... they have never promulgated a regulation, they've never gone through the hearing process.

This is merely some lawyer at the Internal Revenue Service taking a position to deal with a situation that they really haven't dealt with by regulations.

Justice Kennedy: But would the Government have the authority to promulgate a regulation which reaches the result that the Chief seeks to reach here--

Mr. Fox: I believe it would.

I believe they would.

Justice Kennedy: --So, so then it follows from that, that the Government's position is consistent with the statute, if that's true.

Mr. Fox: No, I think it is not consistent with the statute, Justice Kennedy.

I'll tell you why.

Justice Kennedy: They can promulgate a regulation that's inconsistent with the statute?

Mr. Fox: They could promulgate a regulation that would be consistent with this statute but their position, given the regulations as they exist today, is inconsistent with the statute, and I will tell you why.

The reason for that is, as I said earlier, the net... the product liability loss is just a piece of the net operating loss, and an affiliated group filing a consolidated return has only one net operating loss... the consolidated operating loss.

That's the only thing that exists to be carried back three years.

Now, just as you would in the case of the separate corporation, you say, to what extent is that consolidated net operating loss the only thing that they had prescribed that can be carried back three years?

To what extent is it attributable to product liability deductions?

And you can determine that by looking at all of the product liability deductions of the group.

It's right in there and every one of those deductions, regardless of whether the contributing member has negative taxable income or positive taxable income, goes right to that bottom line, and you can prove, dollar for dollar, that the net operating loss is attributable to every one of those deductions.

And that, because of the way they have designed the regulations, they have provided only for the single consolidated net operating loss.

That is what could be carried back three years, that's what a piece of can be carried back ten years.

And there's no getting around that fact.

And you don't need a regulation to say, let's do it on a consolidated basis.

You really don't have to worry about whether we should view, in this particular case, the consolidated group as a single entity or as a group of separate companies.

Justice Scalia: Mr. Fox, did the Government take the same position in the court of appeals that it takes here?

I thought it argued for something a bit different from what the court of appeals came up with.

Mr. Fox: I'm a little confused as to what position the Government is taking in this case, but in the court of appeals they basically argued that the net operating loss you should look at was the negative or positive separate taxable income of a company.

That if you had positive taxable income, then the member didn't have a net operating loss and that was the end of the matter.

The Fourth Circuit rejected that argument.

The Fourth Circuit said, as the Petitioner argued, that the definition of separate taxable income is not the same as the definition of a net operating loss because separate taxable income excludes things like charitable contributions, capital gains and the like.

And so negative taxable income can never equate theoretically, and definitionally, with a net operating loss.

And so the Fourth Circuit went and found a net operating loss some place else.

Justice Ginsburg: Where did they find it, Mr. Fox?

Mr. Fox: Justice Ginsburg, they found it in the regulation 79.

Justice Ginsburg: I know, but had it been argued?

It was... it was the... where did it come from?

Did the Government put it in its brief, or did they just pick it out of the air?

Mr. Fox: I don't recall it being in the Government's brief but the Government from time to time has put out technical advice memoranda and the like, and that argument had been raised by the Government, but I do not recall them arguing it specifically in the Fourth Circuit.

Justice Breyer: If you lose, do we create any anomaly, or is there some... what I'm thinking of is that you have... the Government has, it seems to me, going for it the fact the language is pretty ambiguous.

The language does list some things that should be consolidated, makes no mention of this.

And there's at least one anomaly that's created if they lose.

All right, you have going for you that the statute could be read your way, you could want to play the let's pretend game with the whole set, but is there anything else you have going for you in terms of policy that you want to bring up, or in terms of anomalies that would be created if you lost?

Mr. Fox: Well, I think from a policy standpoint if you go back and look at the 1918 legislative history, that certainly when Congress brought the consolidated return into being, they thought of the affiliated group as one single business.

The Respondent wants to treat every corporation as a separate business.

Well, that's clearly contrary to what Congress thought.

And it may be that you have situations where you can have an affiliated group with corporations in what we would call different lines of business, but that's not what Congress was talking about.

They thought that all of the activity... business activity under common ownership, was a single business.

But even then you could have an affiliated group of five thousand coffee shops, or five thousand vitamin stores, all managed by a separate headquarters business... all financed out of one separate headquarters business.

I think it's pretty hard there to view each separately incorporated coffee shop as a business that's separate and apart from every other business.

And in that case, it would make perfectly sense... perfect sense if one member of the group had a product liability loss, even though it might otherwise be profitable, that this entire group which is all in the identical line of business should be able to avail itself of that.

Justice Stevens: May I ask you a question, Mr. Fox?

Going back to your response to Justice Kennedy about the purpose of the provision... what about the fact that if you do have separate corporations in different lines of business and one of them is profitable notwithstanding its history of product liability losses ten years ago, hasn't that served the purpose of allowing that business entity to recover the loss that has to be otherwise carried back ten years?

Mr. Fox: If that corporation were a stand alone corporation, I would say yes it is.

But I think when you're dealing with an affiliated group, that puts too much emphasis on where you place the particular business.

I mean, a good tax planner, if they thought this was a problem, could get around that by simply moving loss companies around.

And if you take a loss company and put it where you're going to have the product liability deductions, you probably could straighten that problem out.

Justice Scalia: Except... except in the case where you have a company that's acquired between three and ten years.

In that case, you always will end up with a profitable company acquired between the three and the ten years.

You will always have the anomaly.

That company will have taken, as a deduction from its income, its product liability loss, and its taxes will have been reduced accordingly, right?

And then... and then the consolidated company will be able to go back ten years and use some of its deductions once again, in that one situation where you have the acquisition of a profitable country... company between three and ten years.

Mr. Fox: It is theoretically possible, but I would say that if that highly unlikely scenario... I mean, you might have to face up to the possibility of going out and buying a tobacco company and you think, well, it'll throw off some product liability deductions, but you have no idea the extent of that.

You're kind of risking your entire company on some tax dodge.

Justice Ginsburg: But Mr. Fox, isn't that the point of the Government's... the note it makes on page 41?

The footnote in which it says there's no logical reason why Petitioner should be able to use these deductions to create product liability losses for itself simply because the affiliated corporations that actually incurred the product liability expenses realized profits instead of losses.

The anomaly that... as you said, the regulation doesn't cover the profit for a corporation, but it would cover one where there had been losses.

Mr. Fox: Well, I think, Justice Ginsburg, that that is not really a function of consolidated returns.

Take a single stand alone corporation that has an oil business and a computer business.

Now, they might have a product liability in the oil business, but when they report their income, they are reporting the entire company's income and losses.

And if there is a profit in the oil business with a product liability deduction and a huge loss in the computer business, they put that all together and, even though the oil business was profitable and the product liability was more than offset by the oil company's income, because they are in a separate corporation, they can put everything together and they're going to get the product liability deduction.

So the fact that you have disparate lines of business is not the thing that causes the problem, because you can get exactly the same result when you're dealing with a stand alone corporation.

And if that's not a problem there, I don't really see why it should be a problem in the affiliated group context.

Justice Ginsburg: Is your underlying rationale... and Justice Breyer asked you about policy questions... that there's really no reason to treat this affiliated group any differently than you would treat one corporation that had separate divisions?

Mr. Fox: Yes, I think that is exactly the case.

That's the way Congress viewed an affiliated group if you look at that 1918 legislative history.

They say exactly that at some length.

And I think, furthermore, that my ultimate point here is that the plain language of this statute requires that you look at the consolidated net operating loss... that's the only thing we have that's a net operating loss, and you ask, to what extent is that net operating loss attributable to product liability deductions.

We have in the general explanation of the Revenue Bill of 1978 which is cited on page 4 and 21 of our brief.

This provision was explained this way.

Under the Act, the amount of a net operating loss that is attributable to a product liability loss can be carried back an additional seven years is only one net operating loss this affiliated this group has, the consolidated net operating loss.

And it seems to me that the plain language of the statute requires you to ask only one question, to what extent is that net operating loss attributable to product liability deductions?

And that's the end of the matter.

You don't need any special regulation.

To the extent you're a little worried about this hypothetical, number one, the Government can correct that by regulations.

They already have a provision in the Code, Section 269, that allows them to set aside deductions in the case of acquisitions made for tax avoidance.

So I don't believe that we should let that little tail, if you will, wag this dog.

That's a very small point, purely hypothetical, it can be dealt with by regulations.

It can be dealt with by Section 269.

If there are no other questions, I would appreciate reserving my time for rebuttal.

Chief Justice Rehnquist: Very well, Mr. Fox.

Mr. Fox: Thank you.

Argument of Kent L. Jones

Chief Justice Rehnquist: Mr. Jones, we'll hear from you.

Mr. Jones: Mr. Chief Justice, and may it please the Court--

I think it's common ground that none of the corporations involved in this case would be able to claim a product liability loss on a separate return.

That's because the product liability loss provisions provide no extended carry back benefits either for profitable corporations regardless of the amount of their product liability expenses, or for unprofitable corporations that have no such expenses.

So the narrow question presented in this case is whether the fact that this profitable entity that had some expenses of this type is combined with an unprofitable entity that had no such expenses changes the result on a consolidated return.

Justice Stevens: Mr. Jones, can I just ask one preliminary question?

The statute refers to in the case of a taxpayer which has a product liability loss... now, who is the taxpayer?

Mr. Jones: Well, the taxpayer in the 172 context is plainly the individual corporation.

That's the way that all of the provisions of the Code are written.

They are written to apply to the individual taxpayer.

Justice Stevens: And each of the corporations--

Mr. Jones: The only--

Justice Stevens: --is a taxpayer in your view?

Mr. Jones: --Each of these corporations is a taxpayer.

Justice Stevens: Did they each file a return?

Mr. Jones: The only way that they avoid filing a separate return is by electing under 1.1502 to file a consolidated return.

And so the question is, how do you go from the provisions of the Code that dictate how we treat--

Justice Stevens: How many checks does the--

Mr. Jones: --separate taxpayers.

Justice Stevens: --when they file that return, how many people... how many different corporations give the Government money?

Mr. Jones: Well, each of them is severally liable, and so the answer--

Chief Justice Rehnquist: The question is how many give them money, not whether they--

Mr. Jones: --Well, I don't know.

The answer can vary.

Sometimes a check can be drawn from each of the corporations or by any one of them.

They are severally liable for this tax.

That is to say each of them is liable for the consolidated tax.

To understand how--

Justice Scalia: --For the whole tax?

Mr. Jones: --Yes, sir.

Justice Scalia: I mean, you can get the whole thing out of any one of them, not just the aliquot portion attributable to that one.

Mr. Jones: That's correct.

That's Section 6--

Justice Scalia: And indeed you wouldn't know what the aliquot portion would be.

What about the problem that there is simply no net operating loss for each of the individual companies?

Mr. Jones: --Well, that's... that's really... the entire thrust of their argument is that if you start in a consolidated... from a... let me answer the question with a little bit of background.

I don't want to avoid your question, but I think a little bit of background would be helpful.

To answer that question, you have to understand what is the background principle that applies in consolidated returns.

Since the Woolford Realty case, the background principle has clearly been that notwithstanding the consolidation, you treat each of the corporations as a separate tax paying entity except as the regulations provide for consolidated treatment.

So then you have to go to the regulations to see how the regulations provide for the consolidated treatment.

Section 12 of the reg says that in determining consolidated income, the first step is to determine the separate income of each corporation based upon the rules that apply to the determination of taxes for separate tax paying entities.

Under that regulation, it's undisputed that the product liability expenses of each of these corporations are deducted from the income of each of these corporations, and--

Justice Scalia: Before you go further, aren't there some exceptions from normal--

Mr. Jones: --Yes.

Justice Scalia: --I mean, capital--

Mr. Jones: There are some exceptions of items--

Justice Scalia: --Charitable deductions?

Capital losses?

Mr. Jones: --That's right, that under the regulations are treated as consolidated items and aren't part of the calculation of separate taxable income.

Justice Scalia: So you can never really come up with a really genuine picture of what the individual--

Mr. Jones: You don't--

Justice Scalia: --net operating loss, if there were such a thing, was.

Mr. Jones: --The term separate taxable income is not a perfect equivalent.

They say, well, we want a perfect equivalent to net operating loss that we'd calculate for an individual taxpayer, and there are three reasons why that objection has no force.

The first is a simple practical one.

They don't contend that under any definition of separate net operating loss they would have had a loss.

Each of these companies was profitable.

They're claiming the rights of a hypothetical taxpayer that, in fact, in the twenty three year history of this provision has never existed.

There has never been a taxpayer with product liability expenses who had a positive separate taxable income but a negative separate net operating loss.

That has just never happened.

And that's why, in the twenty three years, there's never been any reason for the Secretary to adopt a discrete regulation designed to address these minor differences because they have never been a practical issue.

And that brings me to my third point which is there is no requirement that there be a perfectly equivalent treatment between individual taxpayers and the consolidated taxpayer.

If that was a requirement, we wouldn't have consolidated returns.

Justice Ginsburg: You just used the term consolidated taxpayer--

Mr. Jones: A consolidated return.

If they had to be perfectly equal, we wouldn't have consolidated returns, we'd just have separate taxpayers calculating their taxes and we'd add them up.

Justice Ginsburg: --Mr. Jones, your position that you're now announcing has been rejected, the position that you're taking on brief here is rejected by the Fourth Circuit, and they made it very clear that they weren't buying that, and they had an alternate position.

I have two questions for you.

One is, going into this whole picture with this company, there was an agent... and I assume that this large amount of money had to go up higher in the Service who said, yeah, they're right, under the consolidated regs that now exist, they get this refund.

And it was a Congressional Joint Committee that said no.

So the Service initially agreed.

Therefore, it leads me to think that there has been no consistent clear position that the Service has taken.

Is that right?

Mr. Jones: I think that the Service has taken a consistent position in litigation, and as far as what happened in the negotiations between the parties, I mean, it's often the case that people try to work things out.

But we're in litigation here.

We're trying to decide how the law applies.

Justice Ginsburg: Well then in litigation, since the Fourth Circuit clearly rejected the position that you are pressing on brief, what is the consistent position that you're taking on litigation?

Has the Government ever taken the position that the Fourth Circuit takes?

Mr. Jones: The consistent position that we're taking is that separate taxable income is a workable rule that applies in this context, and that's the point I was about to make which is that Section 1502 of the regs... I'm sorry, of the statute... doesn't tell the Secretary adopt rules that are perfectly equal.

It says adopt rules for consolidation that achieve a clear--

Justice Ginsburg: Mr. Jones, I'm sorry to interrupt on this point again, but as I understand it that isn't the rationale that the Fourth Circuit went on.

Mr. Jones: --That's not the Fourth... the Fourth Circuit had a different perspective.

I'm trying to describe to you what the Government's position is.

Justice Ginsburg: What I'm asking you first is, has the Government ever taken the position that the Fourth Circuit adopted?

Mr. Jones: It's a complicated... the answer to that is very complicated.

The answer to that is, that that reg that the Fourth Circuit relied on does sometimes apply in these cases.

It applied in the Amtel case which was the first case the petitioners brought to challenge this tax issue.

It applied there because there was a separate return year for some of these subsidiaries.

And when the separate return years were involved, then you use the separate net operating loss definition that's contained in the 79 reg.

Justice Ginsburg: But the Fourth Circuit, as I understand it, was not relying on the regulation that relates to separate return years.

That was--

Mr. Jones: They were--

Justice Ginsburg: --Yeah, they were.

That's right.

They were.

Mr. Jones: --That's correct.

They were.

Justice Ginsburg: But they weren't doing it in the limited sense of a separate return year.

They were generalizing that.

They were taking that the regs--

Mr. Jones: They were saying this is a rule--

Justice Ginsburg: --label separate return year, and they were saying, well, we could use this methodology across the board.

Is that right?

Mr. Jones: --They were saying this is an... I think what they were saying is this is an appropriate rule to apply by analogy.

And we don't disagree with that.

What we're trying to explain is how the rules we have in place work.

We don't disagree with the Fourth Circuit that we could apply their rule by analogy.

We don't disagree that in a... if a situation... let me put it this way.

If there ever were the hypothetical situation in which some taxpayer came in and said, well, I have had positive separate taxable income, but I actually had a negative... a separate net operating loss as defined in reg 79, we think that might well be a reasonable resolution.

But it is not the resolution that's currently in the reg.

The resolution that's currently in the reg is valid, though, because it is a legislative rule adopted by the Secretary under Section 1502.

Chief Justice Rehnquist: What resolution is that, and what reg is that?

You say this is resolved by a regulation?

Mr. Jones: Yes, sir.

It's resolved by Section 12 of the regulations which require the separate taxable income to be calculated by reducing from each taxpayer's income the product liability expenses it incurred.

Chief Justice Rehnquist: But this is not the same thing as was pointed out in questions before as the thing you're analogizing it to.

I mean, it's just an analogy, isn't it?

Mr. Jones: The decision of the court of appeals said that the rationale of the reg 79 rule is a workable rule that would make sense if such a situation ever arose, and we don't disagree with that.

What we're saying is that the legislative rules that the Secretary, in fact, has adopted under his broad authority to adopt rules that reasonably reflect the income and avoid the evasion of taxes... the rules that we have are workable rules, and the proof is in the pudding that in twenty three years they have never not aptly applied.

Chief Justice Rehnquist: But your colleague disputes, and the court of appeals happen to agree, that your reliance on 1502-12 simply solves this.

Mr. Jones: I'm not... I'm not sure what you mean.

Chief Justice Rehnquist: Well, you said this is control... as I understand your answer, this is controlled by 1502-12.

Mr. Jones: No, Section 1502 gives us the authority to adopt reg 12.

That's what I'm saying.

Chief Justice Rehnquist: Well--

Mr. Jones: And Reg 12--

Chief Justice Rehnquist: --Which is... which is--

Mr. Jones: --provides a workable rule--

Chief Justice Rehnquist: --Which defines separate taxable income.

Mr. Jones: --Yes, sir.

Chief Justice Rehnquist: But your opponent says that is not controlling, and the courts of appeals have not agreed with you on that.

Mr. Jones: Well, if the... if the opponent agreed with us, we wouldn't of course be here.

Chief Justice Rehnquist: But how about the courts of appeals?

Mr. Jones: We've won this in some courts, we've lost it in other courts.

There's a conflict, which is why we're here.

And what I'm trying to make clear is we don't... we're not saying we disagree with the analysis of the Fourth Circuit--

Justice Ginsburg: But the Fourth Circuit did--

Mr. Jones: --We're saying that the analysis of the Fourth--

Justice Ginsburg: --Mr. Jones, the Fourth Circuit did explicitly disagree with your 1.1502-12 position that you--

Mr. Jones: --Yes, the Fourth Circuit thought that the rules were perfectly equivalent.

Justice Ginsburg: --And it said... it said right in the... it's in 18A of the appendix to the cert petition that that was an incorrect position.

And if you missed that statement, they repeated it later by saying that they often strain to disagree with that position.

So it's clear that the Fourth Circuit rejected the position you're now presenting.

Mr. Jones: I have not argued... I have not suggested to the contrary, and what I've said is that what we... we agree with the Fourth Circuit that if a situation ever arose where this hypothetical distinction between separate taxable income and separate net operating loss ever came up, which it never has, the rule adopted by the Fourth Circuit might well be sensible.

Justice Ginsburg: Well, may I put this question to you, Mr. Jones?

Suppose we agree with the Fourth Circuit and the Sixth Circuit that the position you are taking about 1502-12 is incorrect.

Do you embrace the position that the Fourth Circuit takes as a proper way to resolve this case and all other--

Mr. Jones: It is a proper resolution of this case.

It... it answers questions that the Court doesn't need to answer.

It answers the question of what would happen if these... if this factual situation arose that never had.

And what we're saying is that in that hypothetical situation, that's a good answer, but what we're also saying is that the Secretary is the one who is supposed to adopt these legislative rules, and we don't think that the Court needs to, and therefore shouldn't reach out--

Justice Ginsburg: --But if you don't... if we agree with the Fourth Circuit that the position you're taking is incorrect, so that's out of the picture... we're not going to just assume that we agree with the Fourth Circuit and the Sixth Circuit... there's no split on that, and then so we have to look for an alternative if we're going to use... and rule in your favor, and I'm asking you is the one that the Fourth Circuit took, the one that the Government would urge.

Mr. Jones: --It is... it is the resolution of this case that we think is appropriate on the facts... on the hypothetical facts that the court used in fashioning that rule, but I would simply repeat myself in saying that it's up to the Secretary to fashion these legislative rules.

Justice Breyer: All right, that's... accepting that, and you just point this out to me where I didn't know that the regs actually determined this.

I thought the regs were regs for calculating separable income, et cetera.

And then you throw it all together and you calculate and see a loss overall.

And then the question is, should we count that loss overall as if it were product liability loss?

And what I didn't know is there is something that says, no?

Mr. Jones: Yes, there is.

Justice Breyer: Which one?

Mr. Jones: Well, what it is is, it's the process of the calculations required by the regulations, and that is that you've deducted... you've taken the deduction of the product liability expenses at the separate affiliate level--

Justice Breyer: Yes.

Mr. Jones: --They have not had losses, they have had profits.

Those deductions have been used at that level and cannot go to the consolidated level.

There are no deductions to take to the consolidated level to change the character of the losses of the unprofitable affiliates from the ordinary losses for which they get three years into these extended benefit losses for ten years.

Justice Breyer: And now the wording gets you there in the calculation.

If I go through reading the wording, I won't be able to get to their result.

Mr. Jones: The wording that controls this is the wording of Section 12 of the reg that says in determining the... separate income of each affiliate, the first thing you do is you apply the rules that govern the determination of income--

Justice Breyer: Okay.

No, I'll do it.

I'll go through it.

Mr. Jones: --Okay.

Justice Breyer: If I should, when I go through it, figure out that their reading is possible, then is there some good reading... reason why they aren't right?

I mean, their... their point would be, look, this is supposed to treat the thing like a big business, and if it were a big single business, we could do it, so why can't we do it?

Mr. Jones: Well, it's because Congress adopted in 172 a product liability loss... that provision which is not a subset of losses, it's a subset of the losses incurred by the company that incur the product liability expenses.

What they are doing is--

Justice Kennedy: But why couldn't you say that with reference to any operating loss?

I thought most of the Code was addressed to a single taxpayer.

Mr. Jones: --Most of the Code doesn't turn the character of the allowance on the character of the expense.

Congress in 172(j) focused this special allowance on the taxpayer, in the words of the history, that suffered the loss.

Justice Breyer: But... I'm sorry... I didn't--

Justice Kennedy: --Well, except I think it does.

If, for instance, for legal expense, the corporation has had to have hired a lawyer and deduct a legal expense for something that was a medical expense.

I don't understand--

Mr. Jones: The only--

Justice Kennedy: --your response.

Do you see my problem?

Mr. Jones: --Well, I probably don't understand your question, because what I thought you were saying is what's special about product liability expenses that they should be locused... focused--

Justice Kennedy: And your answer was that the expense has to be related to the reason for which it was incurred, and I say, well, that's true of any expense.

Mr. Jones: --It has to be related to the taxpayer that incurred it.

It has to be related to the entity that incurred it... not to some other entity.

Justice Kennedy: Well, I suppose that's also true with all deductions.

I can't take a legal expense for something that is on my son's separate return.

Mr. Jones: That's right, but if, in a consolidated context, if you consolidate somebody's profit and somebody else's loss, you get a consolidated loss, hypothetically, which ordinarily you get a three year carry back for.

The question is whether this specific situation justifies characterizing that consolidated loss as a product liability loss or for some--

Justice Kennedy: I agree, but the fact that an entity that incurred the expense is different from the entity taking it... presents the same problem as with any other deduction.

Mr. Jones: --It doesn't present a problem unless they're trying to get this special carry back, and they only get the special carry back when this special type of deduction causes a loss for the company that incurred this deduction.

Justice Scalia: Mr. Jones, what is the principal purpose of Part 12 of the regs?

I mean--

Mr. Jones: The purpose--

Justice Scalia: --It isn't designed specifically for this situation.

For what other purpose do you need a definition of separate taxable income?

Mr. Jones: --It is a very important provision, because so many of the provisions of the Code, or... not maybe so many... but many of the provisions of the Code, the ability of a company to use them turns on the specific facts of that company.

There are two other cases that we've cited to you in our brief, the H Enterprises case and the First Chicago case, both of which involve situations where a deduction was available only because of the characteristics of that individual company.

And this relates to the background rule that I described to you from the Woolford Realty case.

You have to... it's necessary to understand that the consolidated regulations are an overlay.

You start with the separate taxable... as separate applications and returns to each individual entity, and then you only consolidate to the extent the regs provide.

Justice Scalia: And do you think that... what I find persuasive in the taxpayer's case here is the fact that net operating loss is only... it's not defined in the regs, it's only defined in the statute, and it is defined to... in a way that would only apply to the consolidated return and not in a way that could apply to the separate returns.

Mr. Jones: Well, consolidated net operating loss is only defined in that way, but the operating losses of the individual entities are defined both in the separate taxable income context which can be negative, the regulations--

Justice Souter: Yes, but isn't that the point?

That they don't define it as net operating loss?

I mean, there is... at least at the verbal level, there is no such concept.

Mr. Jones: --There is no question that the Secretary can adopt... could adopt a rule that did that, but let me point out what would happen then.

The Secretary would then no longer be able to provide for consolidated treatment of the numerous items that they've done... like charitable deductions and so forth.

If we're going to have a separate net operating loss definition for individual corporations, it would have to be only for this issue, and then it would have to take account of, well, we're no longer treating these as consolidated on the other... on the consolidated return.

We would have to make some adjustments there, too.

What the Secretary instead has done is he has a workable rule.

It has the background rule that determines taxes at each individual affiliate.

Because none of these affiliates have losses... none of them have product liability losses to pass on to the consolidated level.

Petitioner's theory would just recharacterize what is a normal loss for its other companies into some kind of special product liability loss.

Now, I would like to emphasize because it is very important to us that Petitioner's theory in this case would lead to serious opportunities for manipulation and abuse.

For example, the hypothetical that's already been described to the Court... you have a long history of profits and a current history of losses, but you don't have product liability expenses.

Justice Kennedy: Do you have authority under 269 to disallow losses if the company is acquired for purposes of tax avoidance, or would--

Mr. Jones: I think the statute says for the principal purpose of avoiding taxes.

Justice Kennedy: --So if I went out to acquire a corporation just to take advantage of this loss, you could invoke 269?

Mr. Jones: I would... we would have to litigate whether we... we would have to establish that was your principal purpose, and I suspect you'd say, well, you had a legitimate business purpose.

Justice Kennedy: Well, I... that was the assumption of Justice Breyer's question.

Of course, you'd have to litigate it.

Mr. Jones: We would have to litigate it, and we would be--

Justice Kennedy: But you're not powerless.

Mr. Jones: --doing it in the face of taxpayers who were obviously planning--

Justice Scalia: But that's the only horrible you've presented... that... I mean--

Mr. Jones: --Well, the other--

Justice Scalia: --the case where that is the principal purpose.

Mr. Jones: --I don't mean to say it's a horrible--

Justice Scalia: And then you complain when we say there's a solution for that horrible by saying, well, but then we'd have to prove that it was the principal purpose.

Of course you would.

Mr. Jones: --I think that the other--

Justice Scalia: It's not a horrible unless that's the principal purpose.

Mr. Jones: --The other horrible is that Congress didn't intend this to happen.

Congress provided no product liability loss benefits for profitable companies, regardless of the amount of expenses they've incurred.

Justice Breyer: To go back to the first horrible... could somebody just do it now, even if you win, by simply folding the acquired company into its company so there's just one entity rather than the consolidated one?

Mr. Jones: No, that doesn't accomplish their objective, because then the acquiring company would be liable for all these product liability expenses.

They'd be a single company, and we wouldn't object then.

We wouldn't have an objection to that because then they would be incurring the product liability expenses as they incurred.

Now, historically for the expenses incurred prior to the date of the merger, they wouldn't be able to use that.

They'd have to have some other theory.

But after the merger, that's not a problem.

The problem is that this is like Woolford.

This is a case where they are coming up with a strategy to avoid the payment of taxes, and even though counselor says this is an unlikely situation--

Chief Justice Rehnquist: There's nothing--

Mr. Jones: --that is this situation.

Chief Justice Rehnquist: --Mr. Jones.

Mr. Jones, there is nothing wrong with a strategy to avoid the payment of taxes.

The Internal Revenue Code doesn't prevent that.

Mr. Jones: But the question is whether the consolidated provisions permit it, and in Woolford Realty the Court said that the mind rebels against the notion that in allowing for consolidated returns Congress meant to provide for such a facile and obvious means of juggling tax attributes to avoid the payment of taxes.

That's what we have... we have a facile and obvious method of juggling tax attributes.

Justice Stevens: But Mr. Jones, you don't disagree with your opponent's hypothetical involving a company with two divisions... a computer division and a hot dog division, or something like that.

Mr. Jones: It's a single corporation.

Right.

Justice Stevens: But it's that... also is sort of contrary to the basic purpose of deduction, it seems to me.

Mr. Jones: No, because the... what Congress was concerned about was the company who was liable for the... whether the company that was liable for the product liability expenses had been fairly treated, and if that company is a single entity, then it has received the income in the past, it has paid taxes on that income, and then when the deductions come up ten years later because the expenses come up later, it's fair to let that company go back and get the monies that they've paid in taxes back ten years ago.

It is not fair, and it's not what Congress provided, to let some other company that had no product liability expenses go back and get their taxes back from ten years.

That's not what 172 is about.

That's not what the consolidated tax return provisions are about.

That's not what this Court or Congress intended to sanction.

This Court said in Woolford Realty that this sort of juggling is not to happen, and in Section 1502, Congress said that the privilege of filing a consolidated return is not to be used as a license for evading taxes.

That's what we have at issue here.

I would like to point out that in Intermet, the Sixth Circuit got this issue wrong principally by relying on Section 80 of the regulations which the Court said creates a default rule under which you are supposed to apply tax provisions first at the consolidated level, unless a regulation otherwise provides.

That's a hundred and eighty degrees off.

Justice Ginsburg: Was it a hundred and eighty degrees off in Intermet to say a separate taxable income's character as positive or negative has no independent significance?

Mr. Jones: Yes, that was also well off the point, the locus of the income at the individual corporate level is often important... it's often critical... in determining the proper tax treatment of that item.

This case is just one more example of that.

For example--

Justice Ginsburg: So it was also wrong when they said a member's product liability expenses affect the group's consolidated net operating loss, dollar for dollar, whether the member has a positive or negative separate taxable income.

Mr. Jones: --Well, actually what affects the income of the consolidated group is the positive taxable income that comes from that affiliate.

Justice Ginsburg: So that can--

Mr. Jones: The positive taxable income goes over and reduces the losses of the other companies.

The Sixth Circuit just got this wrong, and they thought that the--

Justice Scalia: --What are the other examples you were about to give?

Other instances in which it's important to figure out the separate taxable income of--

Mr. Jones: --H Enterprises is a good example.

We cited this in our brief.

H Enterprises involved a company... two affiliates, one of which bought some stock and the other, which borrowed some money and transferred it to its affiliate.

And the affiliate used that money to buy the stock.

Now, there's a limitation on the amount of interest that can be deducted for this kind of equity acquisition, and the question was, well, do you combine these two, or do you look at their separate character?

And the answer of the tax court in H Enterprises was, no, you have to look at them as separate individuals and apply that provision separately first.

Now, another... and so the result was that, well, you didn't hold the interest... the company that borrowed the money subject to this limitation of using that, that when the other company used the money to buy stock.

The other example is... is the First Chicago bank case which we've cited where the question is, well, can a company claim a dividends received deduction?

It can only do that if it holds a certain percentage of the stock of the company.

One affiliate owned less than that amount, and another affiliate owned less than that amount, but when you combine them, they both own more than that amount.

But because you local... you focus your inquiry first on each separate company, neither of those companies qualified for the dividends received deduction because neither of them individually met the requirement.

When Congress has wanted to provide for consolidated treatment of loss items, they've done so expressly.

In 172(h), Congress provides a loss limitation on certain kinds of interest incurred in connection with equity acquisitions and expressly stated that when this provision applies to a corporation that is a member of an affiliated group, it is to be applied to the affiliated group directly.

Congress made no such consolidation... required no such consolidated treatment for product liability losses that are described only a few paragraphs away.

The implication of this seems to be pretty clear... that Congress recognizes the background rule that this Court described in Woolford Realty, which is, you look at each of these companies as individual entities first, unless a regulation provides separately.

That's why I was focusing on how the regulations tell us what to do.

The regulations tell us take these deductions at the individual affiliate level first.

Having taken them at the individual affiliate level... these were profitable affiliates, they had no losses to pass on to the consolidated return.

The losses at the consolidated level are ordinary losses with a three year carry back, not this special ten year carry back that you can only get through juggling of tax attributes as this Court described in Woolford Realty.

I want to just briefly touch on one thing that was raised in the reply brief, which is a new argument and which is wrong.

In the reply brief they say that the Gottesman case stands for the concept that you construe all ambiguities in consolidated return regulations against the Secretary.

Looking at that case, it's clearly not what it holds.

What it says is that penalty provisions are narrowly interpreted.

Penalty provisions are to be construed against the Secretary.

The ordinary rule that this Court established in White v. United States in 305 U.S., which we always cite when taxpayers make this argument, is that there is no policy of lenity.

That the tax provisions are not interpreted in favor of the taxpayer.

Indeed, in a case like this involving deductions which are a matter of legislative grace, any ambiguity is to be resolved against the taxpayer.

This taxpayer has not satisfied the requirement of showing that its profitable affiliates had losses from product liability.

Congress did not intend to provide benefits for any other type of corporation, and the consolidated return regulations don't get them there, either.

I think I've covered what I intended to.

Rebuttal of Eric R. Fox

Chief Justice Rehnquist: --Thank you, Mr. Jones.

Mr. Fox, you have two minutes remaining.

Mr. Fox: The Respondent takes the position that if the regulations do not address a particular provision, that any provision in the Code has to be applied on a separate company basis and not on a consolidated basis.

That is totally inconsistent with the position that the Internal Revenue Service took in both Gottesman and H Enterprises.

In the Gottesman case, the IRS argued that the accumulated earnings tax had to be applied on a single entity basis.

They happened to lose that case, but that was their position.

In H Enterprises, they took the position that the disallowance of interest rule had to be applied on a consolidated basis, and they won the case.

What happened in that case was the taxpayer argued that they had borrowing in one company, and the tax exempt bonds in another company, and that you shouldn't look at the two together.

But H Enterprises is... clearly provides that you look at the whole thing as one, and there was no regulation that said that.

The other point I want to make is that the Government seems to think that you can kind of have a... it's not very important as to how close the definition of separate taxable income may come to net operating loss.

I think that is, in a sense, totally irrelevant because the statute says, you look at the net operating loss.

The regulations have provided for a net operating loss.

It's the consolidated net operating loss.

I see no reason why it would even look at separate taxable income.

The question is, we have the regulations provision for the separate net operating loss, and the issue is, to what degree does that net operating loss that everyone agrees can be carried back three years... to what extent is it attributable to product liability deductions?

When we come up with the number, that's the product liability loss.

And that's the end of the matter, and you don't need a regulation to tell you to get there, because the statute is clear on its face, and the Service has put in the regulation the definition of net operating loss.

Thank you.

Chief Justice Rehnquist: Thank you, Mr. Fox.

The case is submitted.

Attribution:

The Oyez Project

Featured:

United States v. Cleveland Indians Baseball Co. - Oral Argument

Fri, 09 Jan 2009 14:50:29 +0000

Case:

United States v. Cleveland Indians Baseball Co.

Media File:

00-203_20010227-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of James A. Feldman

Chief Justice Rehnquist: We'll hear argument next in Number 00-203, United States v. The Cleveland Indians Baseball Company.

Mr. Feldman.

Mr. Feldman: Mr. Chief Justice, and may it please the Court:

The question presented in this case is whether back pay for purposes of the Federal Insurance Contribution Act, known as FICA, and the Federal Unemployment Tax Act, known as FUTA, whether back pay under those statutes is taxed in the amounts applicable to the year in which it was paid, or the year in which it should have been paid.

In our view, the plain language of the statute provides a clear answer to that question.

All five of the statutory provisions that are directly applicable to this case base the tax on, quote, the wages paid during the calendar year, not the wages that should have been paid, or would have been paid, or could have been paid if events had been other than they were.

Justice O'Connor: You know, I have just one big problem with your case, and that is the case from this Court dealing not with the taxability, but with the calculation of benefits under statutes using the very same language, where we look back at the year when it should have been paid in calculating benefits, and your opponent is going to say, and has said in the brief, that it will cause lots of disruption if we were to adopt your view in that area.

Can you have these statutes using the very same language and have a different interpretation for calculating benefits than you do for taxing...

Mr. Feldman: Let me just...

Justice O'Connor: the wages?

Mr. Feldman: I have one caveat before I answer the question, which is, actually the language in nobody's view, I think, is the same.

The statutes that are at issue here were not at issue in Nierotko.

If any particular language was being interpreted in Nierotko, and I'm not sure it was, they talk about...

Justice O'Connor: Well, but they both have language referring to wages paid.

Mr. Feldman: Right, that's true, but they... it's slightly different.

They say calendar quarters in which it was paid, so it is slightly different, even the provision that might have been applicable there, but beyond that, the Court in Nierotko based its decision on the purposes of the Social Security Act in providing security for people as they reach older age and as they retire.

The Court referred to that, and I think construed the particular statutes it had there in terms of the statutory scheme in which it was found, which was a security scheme of that sort.

Justice O'Connor: Okay, but in answer to my question, are you taking the view that we can leave that the way it is and calculate benefits...

Mr. Feldman: Yes.

Justice O'Connor: the way Nierotko suggests and not be disturbed by the fact that it's a different view here?

Mr. Feldman: I actually think that there's no problem at all.

In the first place I'd point out that that's the way it's been... the Internal Revenue Service since the time of Nierotko has taken the position that the wages-paid rule is a statutory test for taxes.

On the other hand, the Social Security Administration has taken the view that at least for statutory back pay, which wouldn't apply to this case, but at least for statutory back pay they will allocate it back, and that's been going on for 60 years, and it hasn't caused an enormous problem.

In fact, it's caused no problem at all.

As far as the specific... I mean, I could go through some of the specific examples of problems that respondents say would be caused in the statute by their view.

For example, there is a... an exclusion from wages for money that's paid to somebody more than six... on disability, for disability more than 6 months after the person... the employee stopped working for the employer.

Well, I don't see any problem that is created by applying the wages paid for taxes to that payment.

In fact, the problem would be created quite the contrary.

Under the wages-paid rule, you look, you count 6 months after the employee stopped working, which is what Congress wanted to do.

Payments made after that date are not taxed.

Payments made before that date are taxed.

Under respondent's view, you'd have to take all the payments that were made after that date and try to figure out whether they should have been paid, should they have been paid earlier or should they have been paid later.

Justice Ginsburg: Don't those records have to be kept for social security allocation purposes, so the employer... to determine quarters of coverage, would have to supply those records to the Social Security Administration.

Mr. Feldman: Well, not quite.

The Social Security... the issue arises, I would say, with less intensity and frequency in Social Security for a number of reasons.

One is that as a Social Security... under the Social Security scheme, they essentially permit you either... your choice, option of either going back or using the wages-paid rule, and therefore a lot of cases, since you have a choice a lot of cases don't even arise, because they just use the wages-paid rule.

Secondly, under the Social Security scheme, because of the way that scheme works, it's a lot less significant, the allocation decision.

Under Social Security, all you need is 40 quarters of coverage in order to be a fully-insured individual, and most people already have that, and it doesn't really matter whether it's in the quarter that it would be paid or the quarter, or some other quarter it's allocated to.

In addition, under the Social Security scheme, your benefits are based essentially on your average annual earnings.

That's the way they're currently calculated.

It's just an average annual earnings.

It doesn't really matter where you allocate the wages, it won't make much difference for most people's Social Security, because you're taking an average anyhow over some many-year period of time, usually.

Now, I'm not saying it will never make a difference, but the issue arises much less sharply and with much less frequency in the Social Security context, but in any event...

Justice Ginsburg: But my question really is, are you taking a position that the provisions, the FICA and FUTA, however you pronounce it, that those provisions dictate the position that the Government is taking, or are you saying, yeah, they could have gone for symmetry with Nierotko, but this statute could go either way, and our consistent interpretation, the service's consistent interpretation has been when it's paid is when it's income?

Mr. Feldman: No, I think the wages-paid language in FICA and FUTI... FUTA is entirely unambiguous.

It says, wages paid during the particular year, and I think that that ends the question as far as FICA and FUTA goes.

The Court in Nierotko adopted a different construction of somewhat different language in the Social Security Act.

I think the fairest reading of Nierotko is probably that the Court felt that this was not... didn't tie it to any particular... the allocation question... didbn't tie to any particular language, but just decided that an exception of this sort was necessary to accomplish the purposes of the Social Security Act.

Justice Kennedy: Do you think Nierotko was wrongly decided?

You don't ask us to change it.

Mr. Feldman: No, we don't.

It was a statutory decision, and I don't think that there's any basis to overrule it.

I think that they... the Court didn't give any explanation of how it arrived at the conclusion that you have to allocate back based on any particular language of the statute, and that's one reason why I think the best reading of Nierotko is that the Court was just adopting a kind of extrastatutory exception, and saying, given the purposes of the Social Security Act and providing security for people so that they'll know they'll get the funds and won't descend into poverty as they get older, given those purposes, this is really the only way to do it for those purposes.

The Court did not look at the specific language of the statutes here, or the specific changes that those statutes had gone through to arrive at that language.

Originally in 1935, in the 1935 Act, the FICA, what became FICA and FUTA... it was actually all part of the Social Security Act... those taxes were based on wages paid for employment during a year.

That meant, and everybody agreed at that time, you had to look at when the employment occurred, not when the wages were paid.

That scheme was in effect for a few years and the 1939 Congress saw that it caused confusion and difficulties and said, we have to change this, because we don't want to have to... it's easy to figure out when somebody was paid.

Indeed, in this case they stipulated that they were paid in March of 1994 and usually that's a question that doesn't cause any problem, so we're going to base the taxes in 1939 on the wages paid.

Now, in 1946, Congress extended that to the wage-base provision, so by 1946 everything was in line to avoid the kind of confusions and uncertainty that were caused by having to look and see when the employment was performed.

Justice Souter: But none of the statutory changes address this point specifically.

Mr. Feldman: I think, quite to the contrary, I think they do.

I think changing... because I think changes to wages paid was an unambiguous change that required that the tax be based on whether...

Justice Souter: It is certainly unambiguous with respect to the normal payment of wages in accordance with whatever the wage contract is, but if we take the position, and I will confess that I... I'm inclined to, and that's what I want you to address.

If we take the position that the statute simply does not address the problem that we've got here... it addressed the problem of accrual versus cash methods when you're doing your taxing in the normal course, but it doesn't address the, in effect the back-wage problem, if we take that position, why isn't it sensible for us to say the normal, bedrock philosophy of remedial orders is to put the wronged party in the position that the wronged party would have been in if, in fact, the defendant has acted as the defendant should have, and if we take that position, then we're going to, in effect, find the wages payable for these various tax purposes when they should have been paid.

Mr. Feldman: I don't think that that's the... that is the philosophy when you have litigation between the wrongdoer and the wronged party.

I don't think that that's a part of the philosophy of the tax code.

The Government is not the wrong... the party that committed any wrong in this case or in any of the other cases...

Justice Kennedy: Right.

Justice Souter: The Government is a neutral party so far as that's concerned.

Mr. Feldman: this question...

Justice Souter: But why should a neutral party, in effect, have a... in effect a different rule for its taxation from the rule which in effect determines the relationships of the two parties to the litigation?

Why should we have disparate rules?

Mr. Feldman: Because we know... because what Congress was looking for was an administrable rule to apply for the tax system here.

Justice Scalia: Well...

Mr. Feldman: Under respondent's rule...

Justice Souter: But what is... I... we don't have the same problem of administration when we look back with back pay and say when it should have... when should it have been paid that we have when Congress was addressing the problem in 1939, which was an accrual kind of problem in which the taxes are due on wages before the wages are actually paid.

I mean, those are entirely different administrative problems.

I guess I don't really see what the administrative problem is in the back pay context.

Mr. Feldman: Well, I think the administrative problem is that under the should-have-been-paid rule that respondent advocates there's two distinct areas of controversy that don't arise under the wages-paid rule that's in the statute.

First, in our society people are ordinarily paid for services performed during a certain period, so in order to figure out when wages should be paid, you have to figure out when the services were performed, or for what period they're being paid.

That's exactly the inquiry that was required under the 1935 statute...

Justice Souter: Yes, but the...

Mr. Feldman: and that would be reinstituted under this statute.

Justice Souter: Take this case.

Take this case.

What is the problem in this case?

These people weren't being paid for doing piecework.

They were being paid a salary under a contract which, at least so far as the briefs indicated, would call for regular wage payments, so I don't see any administrative problem in applying the respondent's rule in this case.

Mr. Feldman: Well, in every case, there may not be a problem in every case, although I would add, I'm not sure in this case whether it's been developed when the wages should have been paid.

It hasn't been stipulated to...

Justice Souter: Well, do you have any reason to believe it would be difficult to develop that?

Mr. Feldman: I don't know what kinds of arrangements they had, but some times employers pay things early, sometimes they pay late.

There are many, many kinds of employment in this country.

There's casual and part-time workers, there's commissioned workers, royalty-based workers, there's employers who decide to pay early against a later commission.

In all of those cases, what you'd have to do is look back and say, when was the work performed, and when should have been in the ordinary course the wages paid, and it offers an opportunity...

Justice Souter: But isn't that...

Mr. Feldman: a further opportunity...

Justice Souter: But isn't that what is determined in effect in the contract actions that result in the judgments of back pay?

In other words, don't... at the time, as it were, the parties in the Government confront the problem that you raise, haven't they in the normal course already confronted that problem in the lawsuit which results in the back-pay award?

Mr. Feldman: I don't think that that's necessarily so.

I mean, I think one question that frequently, especially when cases are settled, and are not resolved by a final judgment, one question that nobody has to decide is when should the services... when were the services performed, and when the money should have been paid.

You're just paying somebody some money.

You can tell the date that the money was paid.

It's very easy.

But there's numerous opportunities for, both for collusion between parties to say that it should have been paid on whatever date is going to work out best for them.

There's opportunities for disputes between employers and employees about when the work was performed, when the wages should have been paid for that work, because they... employers and employees may themselves have different interests.

There's the same... it's the same confusion and difficulty that Congress wanted to move away from.

Under the...

Justice Ginsburg: On the income tax side, the back-pay award itself...

Mr. Feldman: Yes.

Justice Ginsburg: Back pay was attributable to '86, '87, but it's paid in '94.

For income tax purposes, nowadays it's '94 income, is that right?

Mr. Feldman: That's correct.

For almost all... at least on the individual side, for almost all individual taxpayers they pay on a cash basis, and...

Justice Kennedy: Well, what about for the employer's deduction, I wanted to ask.

Mr. Feldman: You know, for the employer's deduction, it's not in the record here, and I'm not sure on what basis the employer is working, but since the employers and employees have to be on the same year, it really makes sense to look at the individuals, because we do know that the individuals' taxes are going to be on a cash basis.

Justice Kennedy: I take it the employer gets a deduction for the FICA and the FUTA.

Mr. Feldman: Yes, that's correct.

That's correct, and keeping this... keeping the FICA and FUTA taxes on the same basis as the income tax also avoids some further confusion in these schemes.

When Congress enacted the FICA and FUTA schemes, and when they changed it in 1939 and 1946, these schemes were supposed to be simple and easy to administer.

It actually, it follows, in fact, a fortiori from the fact that individuals do this under the income tax and nobody disputed that so far, that it should be treated the same way under FICA and FUTA.

Those taxes apply usually to almost all wages.

There's a few... there are some exceptions, but very few people actually come within them.

Justice Kennedy: It seems to me we have three arguments.

We have the plain language of the statute, as to which you have the slight edge.

You have thee Nierotko, which obviously the respondents do, and in the middle ground you have the ease of administration, and I can't quite tell from the briefs, I think there's something to be said on each side for that.

Mr. Feldman: Well, I don't really see anything to be said, frankly, on the other side for ease of administration.

They argue that there are a bunch of statutory... there are a bunch of statutory provisions defining wages and so on that would be... would come up with results that they say Congress wouldn't have wanted, but all of those provisions are precisely-worded provisions that tie something to payments made during a certain period of time, and Congress advisedly, I think, in adopting those provisions, they didn't say, well, the employer... they're not wages, if the employer was really just giving a gratuitous payment, and so you have to look and see whether it was a gratuitous payment.

They said, 6 months after the employee ceased working, if it comes after, more than 6 months it's not taxed, if it's less than 6 months it is taxed.

Their... and really that's very consistent with the whole FICA and FUTA schemes, where these taxes are not generally as high as the income tax, and the FUTA tax is rather low.

The whole scheme was, you apply it from dollar number 1.

You try to have a simple rule that's easily administrable.

Justice Kennedy: Mr. Feldman...

What happens, say, if it's a small employer, and he's just late on paying the wage?

He pays it in January instead of December.

What's the standard rule for allocating?

Do you just...

Mr. Feldman: You look at the time it was paid, it says in the regulations.

It say when it was actually paid.

The only exception is constructive payment, which comes in very few cases, and that's where it's actually available to the employee but the employee didn't pick up the check or something.

Justice Stevens: Mr. Feldman, can I just ask, you may have covered this, but in the red brief, toward the end of the brief, there were a lot of anomalous examples.

If you follow one rule for benefit purposes, another rule for tax purposes, you get a bunch of anomalies they suggest, and your response to all of that is, as I understand it, that's been true for 40 or 50 years, and it really isn't all that serious.

Is that your answer?

Mr. Feldman: I think, two answers.

One is it has been true for 40 or 50 years, and it hasn't caused any major problems, but second is, I just don't think that there are anomalies, the anomalies would be created.

Let me take another example.

There's the example of a case where payments that are made to the estate of someone who's deceased in the year after they died, are not taxed under FICA and FUTA, but if the payment is made during the year... in the same year that they died, they are taxed under FICA and FUTA.

That provides a bright line.

It's easy to administer.

You go, you look, you see when the payment was made, and you decide whether you have to pay the FICA and FUTA taxes, which is very consistent with how Congress wanted this scheme to work.

Under respondent's scheme, you have to look at all the payments that were made after the year that the person died and try to see, well, was there some reason why they really should have been made earlier, were they late, were they delayed, did the employer not make the payment on time, was there a dispute, whatever, and you have to sort all that out.

I think under the logic of respondent's position, which is, you're trying to put people, the Federal Government in the FICA and FUTA system is trying to put people in the same position they would have been if the taxes had been paid when they should have been, you have exactly the reverse problem, too.

All the payments that were made during the year that the person died, you have to look, well, were those advance payments, should they really have been made in the next year, why shouldn't they be made in the next year, then they're not taxable, and I don't really see any way to distinguish between any of those cases.

I think Congress enacted a precisely drawn statute here with carefully drawn provisions that drew sharp lines and were easy to administer, and the wages-paid rule is the classic example of that, because it's... there's very few disputes about when wages are actually paid, and if it's applied in accordance with its terms, then the result is that you were able to do it, and I don't think any...

Justice Stevens: Of course, their position only applies to back-pay awards, which usually are... you do determine the period when the wages should have been paid in that kind of a context.

It's not just like the year-end bonus, or something like that.

Mr. Feldman: Well, back pay covers... may cover a lot of different situations.

I mean, I guess back pay, as I understand the way they would use the word, which is not the way Social Security Administration views it, is any time when somebody doesn't get... gets paid later than when they should have been, which it could be due to someone's fault, it could be due to no one's fault, and it could be just a brief delay, it could be a long delay, and when those cases are then... a dispute does arise, a significant dispute, and you come to settlement, the parties can just then characterize whenever the wages were paid, if they could agree on that, and the IRS would have a very difficult time disputing any of that, whereas...

Justice Scalia: It could be part of the settlement deal.

You know, you say this date, and I'll settle for a little less.

Mr. Feldman: Right, and that's exactly the problem, and in our view what Congress did was, enacted a wages-paid rule, and they... although... and they were, in 1939 and then when they completed the job in 1946, directly addressing the need to avoid the kind of confusion and uncertainty and opportunity for manipulation that might arise under a should-have-been-paid rule.

The... I would add that the provisions at issue in Nierotko at most... the Court in Nierotko did not discuss or cite any of the tax provisions at issue here.

At the very most, they referred to section 209(g) of the 1939 Act, which had slightly different language from the tax provisions that are in issue here, although I wouldn't make a big deal out of that.

It talked about quarters in which wages were paid, rather than wages paid during a year, but it had slightly different language, and I think the Court's whole approach in Nierotko was driven by its impression of the purposes, the need for security in an old age security system, which is what the Social Security system was.

It would be anomalous to take that approach, that was driven by the purposes of that system and was, insofar as the Court was looking at language at all was driven by language of different provisions that are in a context that's talking about benefits determinations and who's a fully-qualified individual, and apply it to the statutes that are at issue here, which talk about rates of taxation, and are quite clear in speaking in terms of wages paid during a particular year.

I'd just... finally I'd add that the Treasury Department by regulation has for a very long time, since the time of Nierotko, and in fact even before that, looking at some of the wages, the rate provisions of the 19... when they were changed in 1939 has had a wages-paid rule.

It's firmly adhered to that position.

The Treasury regulations give examples of, right in the regulations of cases where some one is paid one year for services in the prior year, and they say no, you go, you look at when the wages were paid, and that answers all questions.

It doesn't say, you then look and see well, when should they really have been paid, or why were they paid late, or should they have been paid later than they were, or any of those questions that could arise.

The IRS, the Treasury regulations also speak specifically in terms of wages actually paid.

That's the basis of the statute.

I don't think that could be clearer, although I think actually the language of the statute is equally clear and consistent with that.

Justice Scalia: Have we given deference to those regs in the past?

Mr. Feldman: The Treasury regulations, the Court has always given deference to Treasury regulations construing the tax code, and these are formal regulations that are in CFR.

Now, in addition, they've been... those regulations have consistently been applied in a series of revenue rulings, including one in 1989, that specifically applied those regulations to this kind of a case, to a back-pay case, and said the wages-paid rule is the one that applied.

That... the Court has generally given deference to revenue rulings.

In the Correll case the Court said that those rulings are entitled to deference, especially in a case like this, where the revenue ruling is a direct interpretation of the Treasury regulation.

Justice Ginsburg: Any distinction between the extent of deference to the Treasury regulations and the revenue ruling, or is it the same?

Mr. Feldman: I think it's the same.

The... I mean, there's a long story that's actually in our brief about the history of revenue rulings.

Before 1961 they were not, did not have precedential value, even within the Treasury Department, and therefore there was no reason to give them deference, and they weren't accorded deference, and there's a couple of decisions of this Court saying that they don't get it.

After 1961, authority to issue those regulations, which had been vested in the Secretary of the Treasury, was delegated to the head of the IRS, and since that time... and then this Court in the Correll case, dealing with one of the... with some of those revenue rulings that came up at that stage said yes, we give deference to the IRS revenue rulings because they're the masters of the subject.

They have to deal with the... deal with these kinds of problems on a daily basis.

Justice Souter: But it didn't say we give them the same deference that we give a regulation?

Mr. Feldman: It was a... Correll was a pre-Chevron case, and so they didn't talk specifically in the language of Chevron, but given the history of the delegation by the Secretary of Treasury to the head of the IRS, I don't see why they wouldn't get the same deference.

The IRS, when they publish revenue rulings, says these don't have the full breadth of scope, because they generally deal with just a narrow issue, and they don't intend that they apply broadly to items beyond specifically the problem that they're addressing, but within that scope, they should get exactly the same deference.

But in any event, our position is consistent with, and really is... our position is the position that's been in the Treasury Department regulations since 19... the early 1940's, and if there were any doubt about what these provisions mean, those regulations should be given effect...

Justice Scalia: Treasury regs adopted by... how, notice and comment rulemaking?

Mr. Feldman: Yes, I'm almost certain.

I mean, these regulations go back way, way far.

Justice Scalia: Well, if it's the early 1940's, it's before the Administrative Procedure Act, and they probably weren't adopted by notice of...

Mr. Feldman: Right, but they've been repromulgated since, and I'm certain... I haven't looked at the Federal Register, but I'm certain they were adopted that way.

Argument of Carter G. Phillips

Chief Justice Rehnquist: Thank you, Mr.... you're reserving, Mr. Feldman?

Mr. Phillips.

Mr. Phillips: Thank you, Mr. Chief Justice, and may it please the Court:

I'd like to essentially focus on three basic points, what the Court held in Nierotko, the importance of the 1946 amendments to the Social Security Act on both the benefits and the tax side, and then finally try to discuss and balance the relative positions with respect to the administrative convenience or inconvenience of the various positions taken here today.

With respect to Nierotko, I think I understand the United States to have finally conceded that the pivotal language in the Nierotko decision is the wages-paid language, and that there is no meaningful distinction between the wages-paid language that was the basis for the interpretation in that case and the wages-paid language that we have inherited now that is the subject of the provisions that are at issue in this particular case.

But to the extent that there is any question on that, I would ask the Court to recognize first of all it's clear that the Court was interpreting the 1939 amendments, which contains that language.

The first paragraph of the opinion refers to quarters of coverage, which was a concept that did not exist prior to 1939, so it clearly had '39 in mind at that point.

And then if you look at the penultimate and the ultimate paragraph of the Supreme Court... of this Court's opinions, it also discusses quite specifically that... the provision that's at stake here and it says, you know, the petitioner argues, to put it into context, the amendments of 1939 use quarters as the basis for eligibility as well as the measure of benefits, and require wages to be paid in certain quarters, and this Court then, in rejecting essentially that argument said, we have no doubt that it, referring to back pay, should be allocated to the periods when the regular wages were not paid as usual.

I think there's no other way to interpret Nierotko except for saying that language of wages paid in the benefits context, certainly, means that you allocate it back to when those wages should have been paid under the... under that particular scheme.

It's a special rule for back pay.

Obviously, it doesn't deal with the general accrual problems.

It doesn't resurrect any of the accrual problems.

It doesn't ask you to try to make those kinds of decisions.

It asks you to say, when would they have been paid if the employer...

Chief Justice Rehnquist: And it's dealing, Mr. Phillips, with the receipt of benefits by a... it was a beneficiary suing.

Mr. Phillips: That's correct.

Chief Justice Rehnquist: It wasn't a tax case at all.

Mr. Phillips: Right, it was a benefits case, Mr. Chief Justice, which is why it then becomes pivotal to turn to 1946.

Justice Kennedy: Well, just on this point...

Mr. Phillips: Yes, Your Honor.

Justice Kennedy: in other words, the concept of back pay is different here than if the employer is just late?

Mr. Phillips: Yes, I think that's correct.

I mean, it might turn out if the employer...

Justice Stevens: And we get...

Mr. Phillips: is late and there's some fault attributed to it, that might be a different issue, but if he just paid at a different time and there's no issue about it, it's not back pay within the meaning of the Federal scheme, so you know...

Justice Scalia: So we...

Mr. Phillips: and obviously, a dispute as to whether this was back pay for purposes of this rule.

Justice Kennedy: So we look to Nierotko to determine the origins of this phrase, of this concept of back pay, or...

Mr. Phillips: Well, there is...

Justice Kennedy: it depends on litigation, or...

Mr. Phillips: Right.

There are regulations that define back pay, and do it in terms of payments that would have been made by the employer, you know, but for the employer's wrongdoing, but I don't... and I don't understand the Government to either, at any point in this litigation to have raised any question as to whether this is fairly describable as back pay.

As I understand the question they've asked the Court to decide is, assuming it's back pay, what's the appropriate allocation rule for that kind of an approach.

Justice Kennedy: Why, if I pay in January for something I should have paid in December because I'm just late, why isn't that back pay?

Mr. Phillips: It may well be back pay, depending on the circumstances.

If the reason I didn't pay is because I've breached the contract, and I have an obligation to pay it under those circumstances, it might well be back pay under those circumstances.

Justice Kennedy: I'm just late.

I'm... my bank account was too small to cut...

Mr. Phillips: I'm sorry?

Justice Kennedy: We just didn't have the money.

Mr. Phillips: Right.

I mean... but I mean, I don't think you're entitled to hold off paying because you don't have the money.

Justice Kennedy: I understand that, but my understanding of the Government tells me that in that case it is attributable to the month in which it was paid, and I'm trying to find out what...

Mr. Phillips: Yes.

Justice Kennedy: how employers are going to tell the difference if we hold for you.

Mr. Phillips: Right.

Well, the back-pay definition in the regulations is, pay received in one period of time which would have been paid in a prior period of time except for a wrongful or improper action taken by an employer, under that circumstance I suspect that would fall within back pay, as the Federal Government itself deals with it, but...

Justice O'Connor: And for income tax purposes of the employees, it would be... we're talking back pay.

It would be the year received?

Mr. Phillips: It is in the year received, as it turns out today, but recall, Justice O'Connor, back when this was all enacted in both 1939 and 1946 it would not have been paid under those circumstances.

There was a whole different regime with respect to income taxes that existed at that time, and against which Congress was acting with respect to the taxing part and the benefits part of the Social Security Act.

Justice Kennedy: Well, but under your view, any late pay is wrongful, if it was due.

Mr. Phillips: Well, it might be.

I don't have a view on that actually, Justice Kennedy.

All I'm doing is reading the reg and saying that they attribute to... you know, the question is whether it's wrongful.

There may be issues...

Justice Scalia: It isn't just wrongful.

It says improper.

Mr. Phillips: Right, and...

Justice Scalia: Wrongful or improper...

Mr. Phillips: And my guess is there would be a basis for which you could make a claim of back pay, but that's obviously not what Congress was concerned about when it modified the rule to make it simpler.

Justice Breyer: Yes...

Mr. Phillips: It was dealing with the traditional accrual problem of payments that you expect in the ordinary course to be paid at times that are different from when the services arise, and then what do you do in that situation, which is a pretty common problem.

It's one I face every year.

Justice Breyer: Well, but the point would be that the Congress did want to make it simpler.

Mr. Phillips: I'm sorry?

Justice Breyer: Congress did change this because it wanted to make it simple for people.

Mr. Phillips: Absolutely, Justice Breyer.

Justice Breyer: And making it simple for people you just look to the... the quarter or the year in which the money was received, and that's when the tax is due.

Now, if we adopt your position, I think I would agree with Justice Kennedy's implication.

Suddenly, it's not going to be so simple any more, and it isn't just an allocation question, it's also a question of what is it you allocate, and sometimes you're going to allocate these payments, and sometimes you won't allocate the payments.

It sounds like a mess.

Mr. Phillips: Well...

Justice Kennedy: That's the...

Mr. Phillips: You know, the Court addressed exactly the same quote, mess, in Nierotko itself.

Justice Breyer: No, they thought... Nierotko was very simple, really.

It was just a question of whether or not people are covered for Social Security purposes.

Mr. Phillips: But it addressed...

Justice Breyer: It would be terrible if you said they're not covered for Social Security purposes simply because the employer never paid them their wages and they got it all in one lump sum after they were 50 years old.

That would be terrible.

Mr. Phillips: Right, but...

Justice Scalia: So of course you allocate it back.

Mr. Phillips: But Justice Breyer, the point is, is that there are still the same accounting questions that will arise under that scheme, that will arise under our interpretation today, and this Court... and the Government argued, don't go that route, because there will be accounting problems.

Justice Breyer: Assuming that they are the same.

Assuming they're the same.

I'm not positive, but I'll assume that, all right...

Mr. Phillips: Well, they are very, very similar, Justice Breyer.

Justice Souter: Okay.

Chief Justice Rehnquist: All right.

Justice Kennedy: Assuming they are the same...

Mr. Phillips: And the Court dismissed those as not insuperable.

Justice Breyer: All right.

What about the other difference implicit in what I asked?

Obviously, where you have a Social Security statute, and people are supposed to be covered, you're going to make a big effort to allocate this backwards, because if you didn't, it would mean that the statute wouldn't serve its basic purpose.

Mr. Phillips: Right.

Justice Breyer: Here, however, what we have is not only a desire for administrative simplicity, but we also have, who knows where the chips will fall?

I mean, let them fall where they may.

Sometimes some employees will be helped, sometimes others will be hurt, sometimes... you know, who knows, and therefore you don't have this overriding statutory goal to get the backwards allocation.

Mr. Phillips: There are two answers to that.

One is, in the 1946 amendments, Congress was very clear when it said, what we want here is conformity on the benefits side and on the tax side, and therefore the ultimate question about administrative convenience isn't the answer.

What Congress wanted was for the two schemes to be the same, so to the extent that the benefits tends to take you back in time, as I think the Government has conceded today it continues to do, in order to comply or to further the overall objective of Congress in 1946, you have to do the same thing on the tax side, otherwise conformity is completely impossible to achieve, and that's the overriding congressional purpose, it seems to me.

Justice Breyer: Who cares?

What's so important about having the coverage question of what quarters are covered for beneficiaries and the tax question of where you pay the FICAs, who cares whether they conform or not?

Why does it matter?

Mr. Phillips: Well...

Justice Breyer: The three examples you came up with, their response to that is, each of them involves, if you're right, the Government collecting less money, and we don't care.

Mr. Phillips: Well, I mean, there are two answers to that.

One is the overall purpose of the Court's mission here is presumably to implement Congress' intent, and if Congress says to you, by adopting exactly the same words for two separate provisions that deal with two different schemes...

Justice Scalia: May I ask you a question on that?

Mr. Phillips: then it seems to me the answer is, adopt Congress'... and tells you we want conformity between the two...

Justice Stevens: Mr. Phillips...

Mr. Phillips: then the only... I'm sorry, Justice...

Justice Stevens: Let's assume Congress said that and meant that completely.

Is it... is Mr. Feldman correct in telling us that despite that clear statement from Congress, for the last 50 years they've been doing just the opposite, and following one rule for benefits and another rule for taxes?

Mr. Phillips: Yes.

For the last 50 years the Social Security Administration...

Justice Stevens: So at least we are... what is called into question is a uniform, consistently followed practice for five or six decades.

Mr. Phillips: Yes, on both sides, though.

Remember, Social Security Administration...

Justice Kennedy: I understand.

Mr. Phillips: has had an equally uniform rule that it has applied since the very day Nierotko was decided, and when the 1946 amendments went into place, and if you look at the lodging that we filed that identifies...

Justice Scalia: No...

Mr. Phillips: a description of this analysis by the Social Security Administration, from day one they said, the Court said in Nierotko, for back pay you have to allocate it back, and that's the way we're going to apply it, and that sort of makes the...

Justice Ginsburg: You disagree with the... Mr. Feldman told us that on the benefits side of the allocation it was really up to the wage-earner, could do it either way.

I can't imagine why... well, in my... in... I think he told us first of all in most cases it means nothing at all.

Mr. Phillips: Right, but that's clearly wrong, because when you're dealing... I mean, it may be one thing for quarters of coverage, which is what he identified, but when you're talking about the maximum benefits of $50,000, and you're talking about incomes that well exceed that, how you treat that money is a big, big difference in terms of how it applies out in a particular situation.

Justice Ginsburg: But there's... if you would create a symmetry between benefits and the tax, you would be creating an asymmetry between the income taxation of the back pay and the taxes that go with that...

Mr. Phillips: But that's an asymmetry that has existed for all time.

There's never been consistency between income taxes and Social Security taxes.

What I'm trying to do is say, when you talk about, quote, Social Security taxes, which defines what kinds of benefits you're going to get and whether you're entitled to benefits in any event, as opposed to Social Security taxes as to how much has to be contributed by the employer, that it ought to be the same.

It should not be that John Butcher, for instance...

Justice Ginsburg: Well, I... in the case of Social Security and that allocation, the employee benefits every time by doing it the way Nierotko... the employee can only be helped.

On the other side, sometimes the employees are helped...

Mr. Phillips: Well...

Justice Ginsburg: sometimes they're not.

Mr. Phillips: Well, I don't know that they'll always be helped.

There are certainly certain circumstances where... it depends on how much income they had, under what... at what point in time.

Justice Ginsburg: But then Mr. Feldman tells us they have an option, if it wouldn't work out for them, to spread it back over...

Mr. Phillips: Well, I don't read Nierotko as having given them that option.

I read Nierotko as saying that, you know, you must allocate back.

That's the answer for back pay, in order to do it.

But you know, if there's some mechanism in there for waiving their rights, I suppose that may be true, but I don't think you can analyze the same language in the same statute adopted at the same time with a command that the two ought to be in conformity to each other, and then interpret them as allowing fundamentally different approaches, and that goes to the core of the question of administrative ease.

Let's be clear about this, there is an entire set of accounting rules for Social Security that exist today, and a complete set of accounting rules that apply under the IRS, and as I understand the Government's position, Social Security is absolutely right in its interpretation of what's required here, so if you're going to have consistency in this approach, the only way you can have consistency is by moving the IRS over to the Social Security side.

Chief Justice Rehnquist: Well, what language, Mr. Phillips, precisely is it in the 1946 amendments that you say insists that there be symmetry?

Mr. Phillips: The Senate report that we...

Chief Justice Rehnquist: I mean the language in the Act itself.

Mr. Phillips: Oh, well, the language in the Act is wages paid.

It's exactly identical in both the Social Security benefits language and the Social Security... excuse me, under the tax provision itself.

Wages paid is the operative language and, as I understand the Government today, they concede that's the key term that we're focusing on, and that language was used, you know, with the express statement in the legislative history, that it was done for conformity, which just reinforces what I think common sense would tell us.

Chief Justice Rehnquist: Is that... is the Senate report cited in your brief?

Mr. Phillips: Yes, Justice... Mr. Chief Justice.

Justice Scalia: Well, I can find it.

Mr. Phillips: It's on page 21 of our brief.

Chief Justice Rehnquist: Thank you.

Mr. Phillips: It seems to me that...

Justice Scalia: Apparently the Internal Revenue Service didn't read that, or didn't think that everybody paid attention to it, or what?

Chief Justice Rehnquist: I...

Mr. Phillips: Well, I hesitate to speculate about what the Internal Revenue Service's motive was here, other than... I do think it's important to put in context, remember, the Internal Revenue... the Government's position here is, this doesn't promote fairness, this doesn't promote revenue enhancement.

The sole purpose that they try to promote is some notion of administrative simplicity, and so they have a somewhat simpler method of dealing with it.

It just happens to do violence to core notions of statutory interpretation, creates two different schemes of accounting that every employer and employee has to deal with, and creates the kinds of disruptions in the scheme that we spent some time talking about under the exceptions under the Social Security...

Justice Scalia: If you want to talk about violence to the statute, Nierotko, it seems to me, does a fair amount of violence to the statute, and I suppose the question is whether you're going to... whether it's worse to extend that violence to both half of... both halves of the statute, or to leave Nierotko where it is as a case that, where a hard case made bad law, taking the word paid not to mean paid in order to prevent Social Security recipients from being read out of the system.

I'm frankly attracted to the latter approach.

Mr. Phillips: And that would... and that might be a colorable argument but for the fact that Congress, before the ink was dried on Nierotko, looked at exactly that language, adopted exactly that language, and engrafted it into the statute on a going-forward basis, and so the notion that the Court might revisit Nierotko, you know, today... I mean, 1) the Government doesn't ask you to, and 2) it doesn't make sense to do that, and second, I don't even understand the Government to be asking you to reconsider it on the benefits side.

What it says is, you can have a tax rule that goes in one direction, a benefits rule that goes in another direction, when the language is exactly identical.

Justice Stevens: Mr. Phillips, this dichotomy that's gone on since 1946, has anybody in Congress tried to straighten this out, do you know?

Has there ever been any motion to clarify this terrible inconsistency?

Mr. Phillips: Well, you know, it's an interesting question, because both sides of the... you know, the Federal Government is obviously of two minds on this score.

I'm not sure who would have generated enough momentum in order to try to get it changed under those circumstances, so as far as I know there haven't been any legislative efforts.

Justice Stevens: Does the general policy that underlies their doctrine of stare decisis have any bearing on what we should do with this case, do you think?

Mr. Phillips: Well, I would hope that the Court would rigorously enforce the ruling in Nierotko and... but beyond that, I think you get more mileage in this particular context, because Congress in 1946 ratified Nierotko and implemented it on a going-forward basis, so, I mean, I don't think there's a... I don't understand the Government to be arguing that we ought to revisit Nierotko at this particular...

Justice Breyer: Will you make a... like a quick summary... I'm asking you repeat yourself, in a sense, but I... Nierotko's a famous case, and Nierotko...

Mr. Phillips: I don't think I appreciated that till today.

Justice Breyer: Yes... but no, it's the other part.

It's a famous case.

It says that... Nierotko is about back pay being covered by the Social Security Act and, more importantly, the Court says that even though the administrators think it shouldn't fall within it...

Mr. Phillips: Right.

Justice Breyer: Congress wanted to, so it's opposite Chevron.

It's the...

Mr. Phillips: Predated Chevron, too.

Justice Breyer: It's always been interesting for that reason, so I just thought, well, gee, that's what this case is about.

They're saying this word, you know, this word wages here, covers back pay.

Now, once they make that decision, they sweep away the little subsidiary argument which is that it couldn't mean that because otherwise you'd have to allocate, and they say, oh, no, go allocate.

All right.

So I think of it, where Congress said that wages include back pay, you allocate, and now I think, this isn't that, and Congress didn't even say that.

Congress wasn't talking about taxes.

The Court never thought Congress was talking about taxes.

They weren't talking about some general allocation rule.

They were talking about the allocation of the back pay which counts as wages for purposes of the Social Security Act.

You see why I kept thinking it was different?

Mr. Phillips: Sure.

Justice Breyer: And you're going to tell me no, it's not different.

Mr. Phillips: Because of the 1946 amendments, and for exactly the reason you identified.

Nierotko is a famous case.

Congress, seven months after the 1946 famous Nierotko decision...

[Laughter]

comes back to this same tax-benefits position, uses exactly that language.

What could Congress have meant?

It clearly didn't mean to overrule Nierotko on the benefits side, and it says it wants the tax side to conform to it.

So in 1946, Congress told us the right answer, and hopefully, 55 years, this Court will tell the IRS that's the right answer, get in line with the Social Security Administration, and affirm the judgment below.

If they need a change, let them take it to Congress.

If there are no other questions, I'll...

Rebuttal of James A. Feldman

Chief Justice Rehnquist: Thank you, Mr. Phillips.

Mr. Feldman, you have 4 minutes remaining.

Mr. Feldman: I just have a couple of brief points.

One is...

Justice Kennedy: Do you agree that it's a famous case?

Mr. Phillips: [Laughter]

Mr. Feldman: It is for me now, moderately.

I think one of the points actually I wanted to make is that, to look carefully at what happened in 1946.

This Court decided Nierotko.

There's not a trace of any indication in the legislative history of the 1946 amendments that Congress had any idea that Nierotko had been decided.

They certainly did not say, we are trying to conform anything to Nierotko, so that's the first point.

The second point is, what they did do there is, they also did not change the specific provision that was at issue in Nierotko, which was a benefits provision.

It was a definition of who is a fully qualified individual.

They didn't change that at all, and so they didn't discuss it.

What they did change was the tax provision for the wage base, and that provision they changed to move it to the wages-paid rule, which they had started to bring in in 1939, and they had said why they did that, to avoid the confusion and difficulties that the other rule had caused.

Finally, then, they changed the wage base in the Social Security Act, which was not at issue in Nierotko, because that had nothing to do with wage bases.

It had to do with who was a fully qualified... they changed that, and they said, well, we're doing this just to conform with what we've done with the tax provisions.

I think if you put it all together, what the clear intent was, was to keep the taxes easily collectible, and to pursue the ease of administration that they had started in 1939, and then just to bring the Social Security wage base definition in line with that, but I don't think saying that meant in any way, or there's no reason to think that Congress thought that what... if they were aware at all of Nierotko, that it had anything to do with taxes.

As far as the Social Security... just two other very brief points.

One is that the Social Security Publication 957 discusses what they... their method is, and they do give an option, because they say you can... you report the back pay on your W-2, and then if you file another filing allocating it back, we'll look at that.

If you don't, you can just leave it allocated on the W-2 for the year it was paid.

And finally, just one other point that I thought was interesting is that the 19... Mr. Phillips referred to the 1943 income tax provision that did allow some attributing back pay to prior years.

That was limited to where it was 15 percent or more of your wages, but this was a statute which they enacted, and it's called Section 119, Back Pay Attributable to Prior Years, and it starts off, if the amount of back pay received or accrued by an individual, and so on.

So when Congress wanted to address the back pay problem in the income tax context, right around this time, they did it, they did it in express language, they kept that into effect, in effect for a certain number of years, they limited it to where it's more than 15 percent of the income, and then they got rid of it when they found that that was too difficult to work, in, I think, 1961 or so.

None of those things happened with respect to, in 1946 with respect to the Nierotko decision, or the FICA and FUTA taxes at issue here.

Thank you.

Chief Justice Rehnquist: Thank you, Mr. Feldman.

The case is submitted.

The honorable court is now adjourned until tomorrow at ten o'clock.

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United States v. Hatter - Oral Argument

Fri, 09 Jan 2009 14:50:31 +0000

Case:

United States v. Hatter

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99-1978_20010220-argument.mp3

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transcript.xml

Transcript:

Argument of Paul R. Q. Wolfson

Chief Justice Rehnquist: We'll hear argument now in Number 99-1978, United States v. Terry J. Hatter.

Mr. Wolfson.

Mr. Wolfson: Mr. Chief Justice, and may it please the Court:

When Congress brought Federal judges within the coverage of the Social Security and Medicare programs, they began to share with the vast majority of all other Americans the costs and benefits of a universal program of social insurance that benefits society at large.

The obligation to participate in those programs posed no threat to the central purpose of the Compensation Clause, which is to protect the judiciary from interference from the other political branches.

As this Court recognized in O'Malley v. Woodruff, judges are also citizens, and the Compensation Clause does not grant them an immunity from participating in the burden of Government, whose Constitution and laws they are charged with administering.

A nondiscriminatory tax that falls on judges as well as most other citizens does not violate the Compensation Clause.

The concern that the Framers had with Congress' possibly abusing its power to set judges' statutory salaries does not apply to Congress' application and extension of a nondiscriminatory tax on income.

Now, the Framers understood that when Congress exercised its authority to enact statutory salaries, it would have the opportunity for mischief.

Justice Scalia: Excuse me, how does that nondiscriminatory get into it?

Suppose Congress simply reduces the salaries of all Federal employees, officers and employees, and judges among them.

Surely the fact that it was nondiscriminatory wouldn't prevent it from violating the Compensation Clause, would it?

Mr. Wolfson: That is correct, Justice Scalia.

Justice Scalia: Although you could say they're clearly not trying to impair the independence of judges.

Mr. Wolfson: That's the holding, of course, of Will, which is that a nondiscriminatory reduction in Federal employees' salaries that includes judges does violate the Compensation Clause, but it's one thing to say that a direct reduction of judges' salaries violates the plain language of the clause, because it is, after all, a diminution of their compensation that is owed to them for their services, but it's another thing... and... but it's another thing to say that a tax, which is not a direct reduction of their compensation but is an obligation that they must share with all other citizens, implicates the Compensation Clause.

Justice Scalia: Why is that, because a tax doesn't have anything to do with their compensation, and therefore it doesn't count?

Why would a discriminatory tax violate the Compensation Clause, then?

Mr. Wolfson: First of all, I think--

Justice Scalia: If it doesn't have anything to do with compensation, you could do it discriminatorily, I assume.

Mr. Wolfson: --I'm not sure it would violate the Compensation Clause itself.

It very likely would violate fundamental principles underlying Article III, a discriminatory tax, even if it didn't fall on judges' compensation.

If... one... there are two, essentially two different principles here.

One is a reduction of judges' compensation, and another is discriminatory treatment of judges in some way which might or might not be directed at their salary or at their income.

I think the same principles would apply, a discriminatory tax principle would apply if Congress--

Chief Justice Rehnquist: Well, what cases support the... your second hypothesis?

We've had cases involving, you know, the Compensation Clause and decided them one way or the other, but what cases support this second line of argument?

Mr. Wolfson: --Mr. Chief Justice, I think the cases like Plaut v. Spendthrift Farm show that there are broader principles protecting the independence of the judiciary that go beyond some political interference, that go beyond just the Compensation Clause, but I want to add, even if I'm wrong, and even if one should analyze the discriminatory tax on judges' salaries under the Compensation Clause, that doesn't mean one would have to also conclude that a nondiscriminatory tax violates the Compensation Clause, because the clause would still be interpreted in light of its central purpose, which is to protect judges from interference with their function by the political branches.

Now--

Justice Scalia: Well, but maybe... you call it a central purpose, but it's not the only purpose, and it's clear that another purpose is to enable those who come to the bench, setting aside a lucrative profession, to be able to be sure that they will get so much money over the term of their lifetime service.

You acknowledge that's one of the purposes.

Mr. Wolfson: --I certainly acknowledge that that is a benefit that the Compensation Clause has, but I think it's... I think it's--

Justice Scalia: A purpose.

I mean--

Mr. Wolfson: --Well, I'm not sure that I agree that that is a central purpose of the Compensation Clause.

Justice Scalia: --You disagree with Alexander Hamilton, then?

Mr. Wolfson: But I... Hamilton said that that would certainly be a benefit of the clause, but I think that even if that's... even if that's so, and even if I agree with you, it doesn't necessarily follow... it doesn't follow, in fact, that every expectation that a judge had, that he brought with him, or her, when taking office, was protected from any disparagement or any adverse effect by later action in Congress.

After all, the same claim was made in Will.

The judges argued that the formula for adjusting the statutory salary had been built into the statute at the time they took the judges, and they fully expected that those adjustments in salaries would come automatically each year, and yet Congress in 2 years prevented those salaries from taking effect.

Justice Scalia: But there, it was because they had not yet become effective, and therefore they were not part of the compensation that the judges had--

Mr. Wolfson: But the broader point is that it just is not the case that every single expectation that a judge has about his financial position when he takes office is something that the Compensation Clause freezes in place.

For example, Congress surely could have raised the rate of the general applicable income tax on all citizens in the exact same amount as was the amount of the Medicare and Social Security taxes in this case, and Congress could have done so, in fact, because it had decided that from this point on these programs of social insurance should be financed out of general income tax revenues instead of a separate tax on income.

Justice Scalia: --Perhaps, but is it fair to equate payments into a retirement system with general taxes?

I mean, when employers offer compensation, they offer a compensation package, which very often includes retirement plans.

Some of them are contributory, some of them are noncontributory, but that is part of the whole scheme of compensation, and it may well be the case that the general taxes are something entirely different, but does that necessarily show that contributions to retirement schemes are entirely different?

Isn't that much closer to involving the compensation of the judges?

Mr. Wolfson: Well, I think that they bear elements, Social Security bears some analogizing to a contribution to a retirement scheme, but it also is principally a tax that is laid on the wages and salaries of every earner.

Chief Justice Rehnquist: It's quite... it's actually quite different from other compensation schemes, where you get out what you--

Mr. Wolfson: Right--

Chief Justice Rehnquist: --a fraction of what you paid in.

Social Security, you can go for just a few quarters and get the whole deal, and pay 60 years and get nothing more.

Mr. Wolfson: --The... not only that, but there's both a floor and a ceiling in Social Security benefits.

Congress has also made clear by statute that it can adjust Social Security benefits, and that there are no contractual or vested rights in a particular level of benefit, so--

Justice Ginsburg: And you could be... you can be a bachelor, or you could have nine children, and it would be the same.

It's a tax.

It's not like the Civil Service retirement system that's also a piece of this case.

Mr. Wolfson: --Right.

Justice Ginsburg: It's not a tax.

Mr. Wolfson: It's a pay-as-you-go system, principally, and it operates on a principle that a large fund is being financed by all taxpayers, and that all taxpayers... and that all wage-earners also derive a benefit from it, but there's no direct connection.

Justice Scalia: This was meant to replace for these judges the Civil Service retirement system, wasn't it, which they previously had been entitled to participate in?

Mr. Wolfson: Actually, no.

The judges... the judges themselves, while judges, did not participate in the Civil Service retirement system.

Now, Federal employees did participate in an entirely separate, self-contained system, CSRS, and Congress did not bring incumbent Federal employees into Social Security on a mandatory basis.

Justice Scalia: Congress replaced that element of compensation with the Social Security system for other Federal employees, right?

Mr. Wolfson: For Federal employees--

Justice Scalia: And yet you say that it really has nothing to do with--

Mr. Wolfson: --Well, I--

Justice Scalia: --retirement or compensation for retirement.

It seems to me Congress thought it very much did.

Mr. Wolfson: --Well, I... no, I don't think that Congress thought that Social Security is a Civil Service retirement system.

It is not a contributory retirement system.

It is... it obviously does, as does a Civil Service retirement system, go to the... go to citizens' interests in retirement income security, and Congress didn't want Federal employees to have to pay twice for retirement income security.

Justice Scalia: Why is the contributory versus noncontributory factor, whether you get out as much as you put in, why does that have anything to do with whether it is realistically regarded as part of your total compensation?

Does it make a difference, when an employer hires you and promises you a certain retirement system, whether you contribute to it or not, or whether, you know, somehow it is tied to your wages or not?

It seems to me it's part of the total employment package.

Mr. Wolfson: Well, first, the question here is not whether judges' Social Security benefits are part of their compensation.

I mean, the question that we are presenting here is whether Congress could ask judges, or could require judges to participate in the financing of a system that operates for the benefit of society at large, and that is the obligation that was extended to judges for the first time in 1983 and 1984.

And the reason why that is different from a statutory form of compensation, or why, I should say, that the concerns that the Framers had with diminishing direct reductions of statutory salary don't apply here, is that when Congress enacts and shapes a general tax like Social Security, it legislates with the broad perspective of society at large, and it doesn't have a narrow focus on the judiciary, and when Congress sets the generally applicable tax rate, it is also constrained by political checks, by the popular political objection to--

Chief Justice Rehnquist: But you could say that Congress did have a focus on the judiciary here, since judges weren't included until 1983, and then it was decided to bring judges in, who had not been in before.

Mr. Wolfson: --Mr. Chief Justice, Congress... it's true Congress brought judges... Congress eliminated the exemption.

It did bring judges within the Social Security system, and that is part of a general progress of extension of the Social Security system over time since 1934 to the present.

I mean, it's one of many extensions that Congress has made.

In 1984, along with Federal judges and new hires in the Federal Government, it brought in employees of nonprofit organizations.

In 1986, it extended mandatory coverage to employees of State and local governments who weren't otherwise covered by a system similar to CSRS.

Justice Scalia: That may be, but when they do come to the step of extending it or not extending it to this very discrete group of individuals, judges, you're confronted with the problem that they may be induced to extend it or not to extend it on the basis of whether they like judges or not, on the basis of whether they think these judges have been coming out with decisions of the sort they like or not.

Once you allow Congress, whether it's part of a step-by-step proceeding or not, to single out judges for an imposition of this sort, you run the risk that, you know, that they're doing it for a wrong reason, and we can't inquire case-by-case whether they did it because they were mad at judges or not.

Mr. Wolfson: Well, first of all, there is no claim in this case that Congress did this for that reason, that Congress extended the coverage of the programs to judges.

Justice Scalia: I don't know how you'd find that out, to tell you the truth.

Mr. Wolfson: Well, second, this isn't... excuse me.

This is not the imposition of a special tax.

This is the... this is eliminating an exemption that had precluded judges from both the costs and benefits of the Social Security program, so that is a--

Chief Justice Rehnquist: Well, but many judges, speaking generally, had already qualified for the Social Security system in private practice.

--Many judges... many judges might have, Mr. Chief Justice.

Mr. Wolfson: Some judges might have not.

Judges also get a benefit that society at large has from having a fiscally sound Social Security program that benefits everybody.

After all, the logic of Social Security is not just that it benefits the people who pay in specifically for what they paid in.

It benefits... it is a program of social insurance.

It benefits us all that other people obtain Social Security benefits and are not impoverished, do not have to draw on public welfare resources--

Justice Breyer: The figures that I have said that 95 percent of those who were judges in 198... '82, '92... '82... '82, 95 percent had already maxed out, so as to that 95 percent, this had the effect of nothing but a tax.

Mr. Wolfson: --I don't think it would matter.

Justice Breyer: That's at least the figures I saw.

Do you have anything to the contrary, or do you think they're not right?

Mr. Wolfson: I think that there was a wide variety in judges' experience, and--

Justice Breyer: You think these figures are not right?

Mr. Wolfson: --I think it probably is the case that the majority of judges, majority of judges were already fully insured.

Justice Breyer: Now, is it also right that... is it also the case that when this was extended to, let's say... how many million in Federal employees were there in... there were about, say, 5, 10 million Federal employees, extended--

Mr. Wolfson: A couple of million, I think.

Justice Breyer: --A couple of million, all right.

As... if there were 2 million, let's say, 1,950,000 it didn't apply to, because there it was just for the future.

As to the remaining 50,000, there were probably less, probably 5,000, maybe 2,000, it did apply to them, but they were given the choice whether to opt in or not.

But for 800, there were only 800 out of that 50 million, or 5... 2 million that didn't... that had no choice, that had to take it, is that right, and those 800 were the Federal judges then sitting, so everybody else could opt out--

Mr. Wolfson: Well, that's not quite--

Justice Breyer: --but in fact only a few had to opt out because it didn't cover any sitting employee but for those few.

Mr. Wolfson: --Well, first of all it's not quite right, which is that in the first place one has to remember that close situation of employees of the legislative branch and Members of Congress, who before 1984 were not mandatorily covered by either CSRS or Social Security, and they were required, as of '84, basically to choose one, and so they were in roughly the same situation as Federal judges, which is that beforehand they were not subject to any mandatory contribution, and the other person who is similarly situated is the President of the United States.

Justice Breyer: The President of the United States and the 800 judges had to accept this Social Security.

No one else did.

Mr. Wolfson: Members of Congress and legislative employees--

Justice Breyer: They had to go into the Federal--

Mr. Wolfson: --They had to accept one or the other.

Justice Breyer: --So... all right.

So, but as to this particular tax at issue, the only ones that had to accept it were the judges and the President.

Mr. Wolfson: Well, they're the only ones who had to--

Justice Breyer: Is that right?

I just want to know if that's right.

Mr. Wolfson: --They're the only ones who had to accept it then, yes, but of course 90 percent of the civilian labor force had to accept it.

Justice Breyer: No, no--

Mr. Wolfson: Right.

No, I understand, but that's right.

Justice Breyer: --Isn't that, what you just said, totally irrelevant, in that isn't the issue whether or not a person who was already employed at that time had to accept it?

I'm trying to just get the facts right.

Mr. Wolfson: I understand.

Justice Breyer: I'm not making an argument, yet.

I want to get the facts right.

Mr. Wolfson: They were the only people who were newly required, as incumbent employees.

Justice Breyer: Now, this is my question, if those facts are right.

Suppose Congress said, I want a general tax, everyone in the United States will pay it, the tax is equal to 100,000 dollars a person.

It's a big tax, but everybody pays it.

No problem with that for judges, right?

I'm... the answer is right, no problem.

Okay.

Now, what they do is say--

Mr. Wolfson: I'm thinking about the end of the question.

Justice Breyer: --No... everybody in the United States happens to get a rebate, exactly of 100,000 dollars, or to make it... and, by the way, our reason for this is not to discriminate against judges.

It's that everybody else in the United States doesn't have this marvelous, guaranteed, nonpayable in retirement system, so we're only leaving out those who have this... who happen to be judges, of course.

Now, a) is that okay, in your view, under the Constitution?

Mr. Wolfson: I doubt that would be okay.

I mean--

Justice Breyer: If that's not okay, and I don't think it is either, what's the difference?

Mr. Wolfson: --Well, the question is... well, first of all, it seems to me that even though Congress is calling that a tax, it really is not a tax.

It's not raising revenue.

It is what is, in effect, a reduction in judges' salaries.

That is to say, if... what it is, is basically is if Congress had done the same thing that it did in Will, but had just called it a tax.

That is, I don't think it would have mattered to the decision in Will if, instead of passing a law that said, this tax... this salary increase is rescinded, if Congress had said, there shall be imposed a tax on Federal judges in the amount equal to the salary increase that they received on October 1, 1979, so I mean, I think the first question is, is that really a bona fide tax of any kind, and so I think that's one question.

Then the second question, even if one gets that point, the second question is, is there a legitimate reason for Congress to treat Federal judges differently from everybody else?

Justice Breyer: Well, there is.

The reason is that they have, guaranteed by the Constitution, a retirement system, and no one else does.

Now, is that a legitimate reason, or not?

Mr. Wolfson: I don't think it would be in the situation that you present, because it doesn't... I mean--

Justice Breyer: No, no, no.

I mean, it's easy to manipulate the hypothetical.

We don't call it 100,000, call it 50,000, have it come out of the retirement committees of Congress, have it viewed as some kind of effort to help people who don't have guaranteed retirement.

I mean, you know, we could fix that up.

Mr. Wolfson: --Justice Breyer, I agree that when Congress treats judges for tax purposes differently than other people who are similarly situated, it has to have a significant reason for doing so, but I would say two things.

First of all, I think that tax equalization, bringing judges into line with the vast majority of other people and also extending, of course, the benefits of the... the attendant benefits of the coverage that I discussed earlier to them as well as everybody else, as well as 90 percent of the civilian labor force, I believe that that is a significant reason for tax equal... for treating judges for tax purposes equally, as all other citizens.

Now, the hypothetical that you gave me is not tax equalization.

I mean, it's... it is imposing a special tax on judges.

So that, I think is... I think that is almost always, perhaps always, a legitimate objective of Congress, which is to treat judges equally with all other citizens for tax purposes, because the Constitution does not require Congress to grant judges a perpetual exemption from taxes.

What it does require Congress to do is to recognize that when judges take office with a particular salary, that they cannot reduce that level of salary.

Justice Ginsburg: Mr. Wolfson, do I understand your argument to be essentially, this is no different than if Congress had initially given Federal judges an exemption from income tax, and they enjoy that exemption... say, a judge when he took office got that exemption.

10 years later, the Congress decides that judges shouldn't be exempt from the Federal income tax, so puts it on.

Now, we decided a case that deals with the prospective aspect of it and said that's okay if someone was coming on the bench, once the tax is in.

We didn't decide the part that says, what about people who are already there.

Mr. Wolfson: Right.

I--

Justice Ginsburg: Is it your view that these two cases are the same?

Mr. Wolfson: --Yes, they are, and that case that you mentioned is basically the case that was decided by the Fourth Circuit in Baker v. Commissioner, after this Court decided O'Malley, and in that case, a panel in which Chief Justice Stone sat, it raised the situation that after this Court's decision in Miles against Graham, Congress exempted judges from the income tax and then, after O'Malley, it brought them back within the income tax--

Justice Scalia: And that's okay, you say.

Mr. Wolfson: --Yes, I think that is okay.

Justice Ginsburg: That's okay.

Mr. Wolfson: Yes, and--

Justice Scalia: You know, there's some science fiction book I read once that had a devilishly clever plot in which one of the protagonists is poisoned, but he has a poison scanner that detects all sorts of poison, so you couldn't get to him that way, and the way they get to him is that they give him something that isn't poison, but that is very addictive, and then withhold it from him, and if he doesn't get it, he will die.

You're saying that you can do the same thing with Federal judges.

Unknown Speaker: [Laughter]

Justice Scalia: You cannot put a new tax just on judges, but when they come in, you can say, hey, guys, we're going to give all of you a special tax exemption, and if you behave yourselves, you can keep that tax exemption, but you get us mad, and you're not going to have that special exemption any more.

You really think that that's okay?

Mr. Wolfson: --Justice Scalia, I think the problem with analyzing it that way is that there's no question that Congress could have raised everybody's income taxes in the exact same amount that it raised judges, that it was equal to the Medicare and Social Security taxes in these cases.

So judges did not have any expectation... if they came into office at the salary of 100,000 dollars and the income tax rate was 30 percent, there's no question, or it isn't disputed in this case, I don't think, that Congress could have raised the general income tax on everybody 5, 10 percent.

It might have required... it might have been required to by economic distress, by wartime.

Not only that, Congress could have imposed what it has called from time to time a surtax, which is, you know, a special kind of tax that is found necessary to impose from time to time.

Now, that has the exact same economic effect as a... as the elimination of the 5.4... the exemption for the 5.4 percent for Social Security taxes and the Medicare tax, so I think it's just wrong to say that the judges had an enforceable entitlement that required Congress to freeze this in place, because their economic situation could have been changed in exactly the same way.

Justice Scalia: Isn't the reason that judges were distinguished from some other categories in this general revision of the Federal retirement system, isn't one of the reasons that they had a guaranteed retirement income, and that was the basis for narrowing the focus to judges?

Do you think that's a fair basis for saying, well, since you have this retirement income, which the Constitution guarantees you, we're going to use that guaranteed income as the basis for treating you differently from other people?

Mr. Wolfson: I think it would be accurate to say that Congress realized that if it was... if it extended the Social Security taxes... and we're only talking about the old age tax here.

I mean, the Medicare tax applies to everybody across the board, so that's completely nondiscriminatory, but as for the OASDI tax, if Congress had required incumbent Federal employees to pay that, they would have been subject to double deductions, and Congress realized that that in itself was unfair.

That is, it would be required to treat alike things that were not, in fact, alike, so the fact that judges had the guaranteed retirement annuity was a difference for treating them differently.

I'd like to reserve my time for rebuttal.

Argument of Steven S. Rosenthal

Chief Justice Rehnquist: Very well, Mr. Wolfson.

Mr. Rosenthal, we'll hear from you.

Mr. Rosenthal: Mr. Chief Justice, and may it please the Court:

We believe that the Court determined the liability issues in 1996 and need not reach them now, but if this Court does reach the liability issues, we believe this case presents the question whether a tax can ever be a diminution in judicial compensation.

We contend that it can in at least two circumstances.

Circumstance number 1 is where Congress or the political branches change the economic tradeoff that a judge makes when assuming the bench, and secondly, where Congress discriminates against Federal judges.

Chief Justice Rehnquist: What authority in our cases is there for either of those, Mr. Rosenthal?

Mr. Rosenthal: Well, with respect to the discrimination, the latter, virtually every one of these cases, especially the Woodrow case, refers to a nondiscriminatory tax.

With respect to the issue of the tradeoff, the tradeoff is derived from both Will and Evans, which refer to the fact that one of the primary purposes, an equal purpose of the clause, was to bring judges... bring qualified judges into the judiciary.

To quote Alexander Hamilton, one of the purposes of the clause was to get people with the requisite knowledge, combined with the requisite integrity.

That was a primary purpose, as he indicated in Federalist 78.

Therefore, the purpose was so that... and I'm again quoting Hamilton.

It was so that a man knew what ground he stood on, and the ground that these judges stood on was, they didn't get... they got a lot of disadvantages, Your Honors, from when they became Federal judges, but one of the small advantages they did get was, all of the plaintiffs were free from OASDI and HI, and that was retroactively changed.

Justice Ginsburg: So would you say on that reasoning that when the Social Security tax came in and everybody in the general population was exposed to it, and the judges were not, that the judges' compensation went up, they had an increase... they had an increase in compensation, therefore, that couldn't be decreased later on.

Mr. Rosenthal: Well--

Justice Ginsburg: You would have to say that, that exempting them from the tax increased their compensation.

Mr. Rosenthal: --Well, I would prefer to say it the other way.

Our view is that compensation refers, Justice Ginsburg, to what's available for the support and sustenance of a judge.

When our clients, when these plaintiffs took office they had available to them the stated salary, but the stated salary without a deduction for OASDI and HI, and--

Justice Ginsburg: But if they couldn't diminish the compensation, and this is a diminution, you argue--

Mr. Rosenthal: --Yes.

Justice Ginsburg: --then equally, it had to be an augmentation when the Social Security first came in and the judges were exempt from it.

If it didn't increase their salary, how did it decrease their salary?

Mr. Rosenthal: Well, I... I'm not sure how I answer the question about whether it was... the exemption constituted an increase.

It may have, but it's quite clear to me that the imposition of the tax definitely constituted a decrease, and this was a policy decision, Justice Ginsburg, that was made by Congress in 1935.

Chief Justice Rehnquist: What about a judge who has served... this is perhaps a rather... a very old judge, who was serving in '37.

When they came in, they're exempted, so unlike the rest of the population the judge gets a benefit that the rest of the population doesn't get.

Then he continues to serve until 1982.

Then the exemption is taken away.

Now, he's in no worse shape now than he was when he went on the bench in 1936.

Mr. Rosenthal: Your Honor, that is admittedly not this particular case.

What that is is actually the evidence case itself.

That was a case in which the judge took office before the tax was imposed on the general public.

Our position is that the... that a general rate increase which is uniform for the entire population does not... and applies to everybody, does not change judicial compensation, and although we believe that the principle of evidence is correct, we believe there is a possibility, Mr. Chief Justice, that the particular facts of evidence might have been different, depending on whether Evans was appointed in 1912 or 1915.

Chief Justice Rehnquist: What about a change in the tax rate?

Mr. Rosenthal: No.

Your Honor, if it's a uniform change in the tax rate, that doesn't go to the purpose of the clause.

What we're looking for are changes in taxation which will induce justices who are in office to leave office, or lead potential candidates not to join the bench.

Chief Justice Rehnquist: It seems to me that's really stretching Article III.

I mean, it's a perfectly good policy reason, but I don't think our cases have... at least in their holdings haven't extended Article III to that length.

Mr. Rosenthal: Well, I think, with respect, I think that a fair reading of Hamilton... Hamilton's--

Chief Justice Rehnquist: Well, Hamilton's not a case.

Mr. Rosenthal: --No, I understand, it's not a case.

But in reality, the only case that is here, the only case which has dealt with this issue is Evans v. Gore, and Evans v. Gore might have used broader language, but it didn't deal with this particular case.

Chief Justice Rehnquist: Well, O'Malley casts some doubt on Evans against Gore, didn't it?

Mr. Rosenthal: On the broad reasoning of Evans v. Gore, but O'Malley does... because the Court overturned Miles but didn't overturn Evans, I think a fair reading of this Court's case law, reading the three cases together, is that the principle we're advocating, a change for a sitting judge in... that changes the economic tradeoff, is prohibited by the Compensation Clause.

That's the principle we derive from reading those three clauses together, and I--

Justice Ginsburg: All that was involved in O'Malley is it was somebody who came on board--

Mr. Rosenthal: --After--

Justice Ginsburg: --after the tax, so the Court didn't have to deal with somebody who was already a judge when the tax came on, but is your--

Mr. Rosenthal: --That's correct, Your Honor.

Justice Ginsburg: --I think I grasp your argument correctly that you would say, if the... there is no income tax, and there are sitting judges, and then Congress puts an income tax on the general population, everybody, you can't put it on the judges who were appointed to the bench before the tax came in.

Mr. Rosenthal: No, that isn't... our position is, this Court doesn't have to reach that question.

Our position is that if Congress were to adopt a new tax today, and were to impose it uniformly on both judges and nonjudges, there would be no incentive for a judge to want to leave the bench.

There would have been no disincentive for him going on to the bench.

Justice Souter: But it changes the tradeoff.

You were making a tradeoff argument before, and it seems to me that Justice Ginsburg's question goes right to the tradeoff, and if your tradeoff argument is right, it seems to me you've got to say, no, it can't... that tax can't be imposed--

Mr. Rosenthal: Well, I may have misunderstood Justice Ginsburg's question.

Justice Ginsburg: --I'm deciding whether to take a judgeship.

Mr. Rosenthal: Yes.

Justice Ginsburg: And there's no tax on my income.

Mr. Rosenthal: In the private sector or on the bench.

Justice Ginsburg: Right, and then I take the bench, and they... but I know what my salary is.

Mr. Rosenthal: That's right.

Justice Ginsburg: And then there is a tax.

Mr. Rosenthal: Imposed on--

Justice Ginsburg: Imposed on everybody, so my take-home pay is less, because of this tax.

Mr. Rosenthal: --I would submit, Justice Ginsburg, that on that fact pattern there is no incentive to leave the bench because the tax is the same on both sides of the equals sign.

Justice Souter: Sure, but the income isn't.

When I... the theory of the tradeoff is that I go on the bench, I take less money, but I know where I stand, and it seems to me that argument is just as strong when the tax goes on everybody.

It's quite true, I can go out and start earning a living under different conditions, but I... the deal is being changed.

Mr. Rosenthal: Our position is that, although that additional category might be covered, we don't need to reach that question in this case.

At least in our view of the tradeoff, Justice Souter, we don't need to deal with a case where there is a uniform change in rates or a uniform change in--

Chief Justice Rehnquist: But I think it does cut against your tradeoff argument.

A judge can go on the bench, no income tax anywhere, saying, I'm getting 100,000 a year for this job, I've got so many kids to educate, I can just make it the way it is, and I'm willing to sacrifice whatever I would have... more I would have made in the profession.

But then the tax comes along and the tradeoff, what he had bargained for is no longer there.

Mr. Rosenthal: --Well, Your Honor, I understand that position.

Justice Scalia: I really don't think Hamilton would have bought your argument there.

I think... you know, the judge knows where he stands--

Mr. Rosenthal: Well, I think the imposition of... this Court held in Evans v. Gore and that the imposition of a new tax does violate the Compensation Clause.

We don't reach that issue because we have a more limited circumstance.

We have a case where judges take office during a 50-year period in which Congress had a policy in effect that a tax would not be applied.

This is not a transitory issue, I might add.

Justice Kennedy: --Well, under that same reasoning, if the judges take office and there's no tax for Social Security, and there's a Social Security tax on everybody else, under that reasoning, if Congress decides to repeal the Social Security tax on everybody else, the tradeoff has now been changed as well.

Mr. Rosenthal: And if it did... if it did repeal the tax on everybody else and left it in effect--

Justice Kennedy: No, so... even if the judges still don't pay it, they're still in a less advantageous position vis-a-vis everybody else under your tradeoff argument.

Congress can't repeal the tax on anybody else, either--

Mr. Rosenthal: --Well--

Justice Kennedy: --without violating your tradeoff theory.

Mr. Rosenthal: --Well, you would have to be adversely affected by the tradeoff, not advantageously.

Justice Kennedy: Well, you're still disadvantaged vis-a-vis the public where you... compared to what it was when you took the bench.

Justice Scalia: This is my poison example, it's the same thing.

Mr. Rosenthal: Look--

Chief Justice Rehnquist: The poison example depends on the idea that judges are addicted to money.

Unknown Speaker: [Laughter]

Chief Justice Rehnquist: Given the present state of judicial salaries you really can't say that, I think.

Unknown Speaker: [Laughter]

Justice Breyer: I take it your basic point, I mean, whether you're right or you're wrong, I thought it's well-established law that a uniform tax applied to everybody is constitutional, and you agree with that, I take it.

Mr. Rosenthal: --We agree with--

Justice Breyer: Whether it fits your reasoning or whether it doesn't, that's still the law.

Mr. Rosenthal: --We agree that a uniform imposition of a tax, a uniform change of tax--

Justice Breyer: All right.

Now, we have two things here in addition.

One is, it's not a uniform tax.

It's only applying to some people and not others, in your view.

Mr. Rosenthal: --That's correct.

Justice Breyer: And the second thing is, the third thing is, it's not only not uniform, it is also discriminatory.

Mr. Rosenthal: And if I could... because I don't want to lose the discriminatory point, let me provide you the facts, because I've been involved in this case for 12 years.

First of all, of the Federal employees--

Justice Breyer: Are there any plaintiffs still left?

Unknown Speaker: [Laughter]

Mr. Rosenthal: --Thank God, there are.

We have... we had 2-1/2 million, approximately, Federal employees to whom this tax was not applied.

Those were incumbent Federal employees who were not required to join OASDI.

That represented 99-1/2 percent--

Chief Justice Rehnquist: But they were required to join that or something else.

Mr. Rosenthal: --No, actually, they were already in CSRS, and they were allowed to simply stay where they were, but they were not required to join OASDI.

Justice Ginsburg: But they were already having a bigger bite taken out for the CR... the Civil Service retirement was a larger percentage of their salary than the Social Security would be.

Mr. Rosenthal: I believe--

Justice Ginsburg: So if you were socking them with Social Security on top of the 7 percent for Civil Service, and then putting 5.7... I think those employees would say, we've been discriminatorily impacted.

Mr. Rosenthal: --All of that, I... we view as being form over substance, because... well, because the Government sets the salaries and then takes 6, 7, 8 percent out.

They could have just as easily have set the salary at the lower level and said, we give you this benefit, which is what they did with judges.

Instead of saying, you get paid X dollars and we take out 10 percent for your retirement annuity, they simply set the salary and say you get the retirement annuity.

We view that as essentially artificial.

It's just... the fact that it's taken out is just a matter of the semantics of the way the statute was enacted.

Justice Breyer: But you were just giving the numbers that I was quite interested in.

I'm sorry--

Mr. Rosenthal: Let me give you the numbers--

Justice Breyer: --the right numbers.

That is to say--

Mr. Rosenthal: --Your Honor. 2-1/2, 90--

Justice Breyer: --before you tell me the numbers--

Mr. Rosenthal: --I'm sorry.

Justice Breyer: --is it right to this?

I'm trying to think of people in the Federal Government who get a paycheck once a month.

Now, most of these people don't have as good a retirement program as judges, so it's already... that paycheck is right there.

It's already reflecting a great thing for judges, okay.

Now, we look at that paycheck.

Now, I want to know... I'm just thinking, some people will get a smaller one because of Social Security.

Other people won't get a smaller one at all than they had been getting.

Okay, I want to know who's getting a smaller one than they had been getting, and who is getting the same one they had been getting?

Mr. Rosenthal: I'm happy to answer that question.

The Article III judges and the President of the United States are in that category.

The... in the reply brief, the Government for the first time in this litigation suggested that there might be a small component of congressional employees that might also be in that category.

Justice Breyer: Let me be clear.

Mr. Rosenthal: Yes.

Justice Breyer: There are 2-1/2 million.

800 of those, namely the Federal judges, plus the President, are getting a smaller paycheck.

Nobody else is.

Mr. Rosenthal: That is correct.

Justice Breyer: That is contrary to what the SG just said, because the SG just said there are also some people in Congress.

Now, who are those people?

Mr. Rosenthal: Well, there was a theoretical possibility that you had not been in CSRS before, and the Government for the first time in the reply brief raised this issue.

I've done some inquiries, and I am informed that that set of people who did not elect CSRS is either very few or none at all, and the reason for that is, it was almost irrational not to elect CSRS because it's refundable, so if you were a youngster who was just out of school and went to work for Congress in 199... 1983, you elect CSRS because 2 years later you can get the money back.

Justice Breyer: You're saying, as of the date that this took effect, there might have been some people in Congress who were not already having a deduction from their paycheck, but you believe that number is zero.

Mr. Rosenthal: Zero or--

Justice Breyer: But if it is more than zero, it's very small.

Mr. Rosenthal: --It's very small, Your Honor.

But of the 2-1/2... of the 2-1/2 million, we're talking about, a number in the three digits or the low four digits.

The fact is... and that is the basis of our discrimination argument, and I would point out that the election that was given was not just given once, it was given three times, so if you were fool enough to miss it the first time, you were given a number of opportunities to opt out of the deduction from your salary, and that is the basis for our discrimination argument.

The Government says, oh, we have a rationale for discrimination, and that is equalization.

I would answer that, number 1, this Court's decision in the Will case said, equalization can't justify a diminution, because the Government made the same argument in Will.

They said, oh, we lowered Federal judges' salaries, but we were lowering all Federal employees' salaries at the same time, and this Court said, equalization can't be a rationale.

But secondly, the fact is that it doesn't take a very creative legislature to come up with some reasonably sounding rationale to justify a diminution in a particular case, and equalization, which is an argument concocted... excuse me, an argument presented by the Solicitor General's office, nowhere appears in the legislative history of any of these statutes.

There's nothing... this equalization doctrine, as we point out in our brief, is nothing that appears in the statute or in its legislative history.

They didn't say, we need to tax Federal judges because we need equalization.

We think, at a bare minimum, for this argument to be honored by this Court, at least Congress ought to say, we wanted to equalize Federal judges.

We still don't think it's constitutional, but--

Justice Souter: Is there any evidence in the legislative history, or any evidence that might have been admissible in this case, that there was a discriminatory intent?

Mr. Rosenthal: --No, and this Court has never required discriminatory intent.

In Will, recall, Justice Souter, there was an increase for a mere 12 hours, and then the salaries dropped back down again.

There was no fleeing from the Federal judiciary.

Justice Souter: No, that's quite true, but I mean, that was a case in which it was... in effect, it was easy, because it was stated salary, and you could say, however you literally read the Compensation Clause, this had to be within it.

Now we're not in such a situation.

We're saying, well, this isn't so clearly literally within the core of the Compensation Clause, and maybe one of our... maybe our principle criterion ought to be to determine whether this is also prohibited, since it gets away from the core, is a discrimination criterion, was it used to discriminate for purposes of cowing the judges and so on, so the fact that in the core case we didn't look to it doesn't mean that we shouldn't look to it here.

Mr. Rosenthal: If I could suggest a case which I think is quite analogous, and that's Davis v. Michigan Department of Revenue.

As the Court may recall, that was a case in which State employees were exempted... State retirees were exempted from a tax on their retirement benefits.

Federal employees and the rest of the Michigan public had to pay income taxes on retirement benefits.

This Court held, under the intragovernmental immunity doctrine, that that was discriminatory.

There was no intent to discriminate against Federal employees.

Justice Souter: But isn't that because that's what the intragovernmental immunity doctrine means?

In other words, it was discriminatory as a matter of law, rather than discriminatory as a matter of intent.

So I guess you would have to say, on that analogy, anything which is unequal to the extent of a penny is, on the discrimination criterion, going to be discriminatory as a matter of law, and I guess that's what you are saying.

Mr. Rosenthal: I think that is what we're saying, and obviously the penny... I mean, if there were a penny drop in stated salary, that obviously would be unconstitutional, but we infer the intent from the facts.

Chief Justice Rehnquist: Well, if we get outside the Compensation Clause, several recent congressional pay raises in 1989 gave district judges a higher percentage pay raise than court of appeals judges, court of appeals judges a higher percentage pay raise than Supreme Court justices.

Now, would that be grounds for saying that maybe Congress had it in for the Supreme Court?

Mr. Rosenthal: No, Your Honor.

I mean--

Chief Justice Rehnquist: Well, why not, under your theory?

Mr. Rosenthal: --Well, because first of all we're dealing... all of those cases are by common consent increases, and this Court's holding in various cases give Congress very broad power when one is dealing with an increase.

The discretion with Congress is how much to increase.

There is no dispute... there is a factual finding by a rather unsympathetic trial court that there was a reduction in our salary in this case.

There was a reduction in take-home pay, so we're dealing here with a reduction in take-home pay, and the question in this case is, was it an unconstitutional reduction?

So we distinguish it from cases where there are different levels of increase, where, frankly, political factors do play a role, but that was a decision made by the Framers, that when you deal with increase Congress has a much greater role than with a decrease, where a prophylactic rule has to be--

Justice Breyer: Is the word discrimination applicable here or not?

My check is 200 dollars smaller this month.

No one else's is but for judges and four other people, and the reason is not that they don't like my opinion.

The reason is because I have a constitutionally guaranteed pension, something that judges only have.

Now, those are the facts.

Is that discrimination?

Mr. Rosenthal: --Well--

Justice Breyer: In a sense, it's not, because they're not doing it because they don't like my opinion.

In a sense it is, because they're picking on a characteristic that belongs only to judges.

Mr. Rosenthal: --Well, I agree--

Justice Breyer: What is it?

Mr. Rosenthal: --Well, I think the word discrimination is used to cover a number of things.

It doesn't necessarily, Justice Breyer, just include an intent by Congress.

It includes exactly the circumstance you're describing, in which a distinction is made between Federal judges.

Suppose the distinction weren't merely based on the pension, but the fact that we think you should get less because you've got a lifetime job and everyone else holds their job at the pleasure of the President of the United States.

Any factor that inheres peculiarly within the judiciary, and is a basis for a distinction, I think could also be a basis for finding discrimination.

In other words it covers a broad mix of factors.

Justice Scalia: Mr. Rosenthal, does this targeting of judges almost exclusively apply to both programs, or just to one of them?

Mr. Rosenthal: No.

This would only apply to the OASDI.

Justice Scalia: Okay.

Mr. Rosenthal: We agree with that.

The HI was more universal.

Our first argument about the tradeoff would have to apply to the--

Justice Ginsburg: But you're saying the second tax is no good, either, then... as I understand it... or are you just saying the OASDI?

Mr. Rosenthal: --The discrimination argument, Justice Ginsburg, only applies to the OASDI, because it doesn't apply to the HI.

Justice Ginsburg: So then to that extent you're saying, Congress has a choice.

Either it taxes... it gives no exemption, ever, to judges, because if it gives them an exemption, it can never take it away, so it's got to treat judges... it can't give them preferential treatment, in other words, if it gives them preferential treatment, that it's stuck with that, but you--

Mr. Rosenthal: Well, that's correct, Your Honor.

If I could just give you an analogy, suppose Congress next year, instead of providing an increase in stated salaries, said, all judges can take 10,000 dollars tax-free, 10,000 dollars of their income is tax-free.

I point out this is not so unusual.

Congress for a number of years gave the President 50,000 dollars for expenses tax-free.

I would submit that becomes part of a judge's compensation, and Congress... the Congress can't, 10 years later, decide to take it away.

Justice Ginsburg: --Explain how that... you've answered my question, did the judge's compensation go up when everybody else was exposed to this tax and the judges weren't, and you resisted saying that yes, they got an increase in compensation, even though their salary remained the same.

Mr. Rosenthal: I resist it because exemption from a tax... I think now that I've used my hypothetical, I think if there were at least one directed to judges, if there were an exemption, that might be interpreted to be an increase in--

Justice Scalia: You wouldn't say, as I understand your argument... I don't understand why you wouldn't... that if everybody in the country had a 10,000 dollar exemption, your first 10,000 dollars is for free, okay, and then they took it away for the whole country, is it your contention that judges alone would have to be--

Mr. Rosenthal: --If it were uniform throughout the United States, we're not contending that that would constitute a diminution--

Justice Scalia: --I understand that's your position, and it's a reasonable outcome, but I don't see why the logic of your argument supports that.

Mr. Rosenthal: --Because, at least on the discriminatory point, it wouldn't be discriminatory.

Justice Scalia: No, on the discriminatory point I understand--

Mr. Rosenthal: But I--

Justice Scalia: --but you're using this argument for the aspect of your case in which there is no discrimination.

Mr. Rosenthal: --I admit that these represent close cases, but our position... first of all, it's not this particular case, but moreover, I think changes in taxing, if they were uniform and taken away from judges, my inclination is not to be arguing here that that's part of compensation.

Justice Souter: In other words, you're saying for the 10,000 exemption just what you were saying for the original tax, which is nondiscriminatory.

Mr. Rosenthal: Yes.

Justice Souter: Yes.

Mr. Rosenthal: Let me briefly touch on the last point, the claim of the Government that this increase was terminated by subsequent increases.

Our position is very simple.

A congressional action doesn't remedy or terminate an unconstitutional diminution if the judge's compensation is the same, unless it is the same as it would have been but for the unconstitutional diminution.

We are subscribing to a but-for test.

It's quite clear that the increases that took place after OASDI and HI were imposed were general cost-of-living increases that applied not just to judges but to broad categories of Federal employees.

We would have gotten those anyway, and in that circumstance it can hardly be said that those terminated or remedied our particular diminution in this particular case.

We do contend, however, that if Congress were to provide us with the amount of our diminution plus interest, that would compensate us for past periods.

We urge this Court to affirm the Federal Circuit and hold that in order to vindicate both the text, which we believe is clearly applicable in this particular case, and the purposes of the Compensation Clause, that the plaintiffs are entitled to the relief that's ordered.

Rebuttal of Paul R. Q. Wolfson

Chief Justice Rehnquist: Thank you, Mr. Rosenthal.

Mr. Wolfson, you have 5 minutes remaining.

Mr. Wolfson: Thank you, Mr. Chief Justice.

When Congress extended Social Security taxes to Federal judges and to other Federal employees in 1984 it had several objectives that had to be balanced.

One objective was to bring as many people as possible within the Social Security system, people who had been exempted from it in order to sustain the fiscal soundness of the system.

Another objective was to treat Federal... people in Federal service similarly in that each should be subjected to one, but only one, contribution for retirement income security, and a third was, Congress understood that Federal employees in the Civil Service retirement system had a large vested interest in that system, which had been in place since 1920, and that it would be extremely disruptive just to terminate it and start as if it had never existed, especially because many Federal employees would not have been able to accrue enough service in Social Security after that point to become eligible in Social Security, especially if they were older.

The Federal... the Civil Service retirement system allows retirement at age 55.

It also is more expensive on the cost side for Federal employees than Social Security in some sense, because the contribution rate is higher, and there was no earnings cap on Social Security... on CSRS, as there was under the old age tax system, so all of those factors had to be balanced.

The point is, at the end of the day, Federal judges joined virtually everybody else in our society in being subject to a 5, 6 percent mandatory contribution for a retirement income security system, and that's what I mean when I say that the overall objective of Congress was equalization, and that Congress treated them no differently at the end of the day than it treated everybody else.

Now, it is true, there are issues that come up in a transition, as there are any time when Congress extended Social Security, or where a State might adjust... a State might adjust an exemption, for example, the intragovernmental tax immunity system doctrine was alluded to.

Well, there was a time when States exempted all Federal employees and Federal contractors from their taxes because they thought they were required to under this Court's decisions in Collector v. Day.

Then along came Graves, and the Court said that States could tax Federal employees and Federal contractors on an equal rate.

The States were required to adjust their systems, or had the opportunity to adjust their systems, and they were able to do so in many different ways.

It required some... it required a lot of adjustment because of the ways that different people had been treated differently, and this Court has many cases on that point, reviewing the adjustments that the States made, but the point is, the principle that emerged from those cases was, what was required at the end of the day was nondiscriminatory taxation of those who dealt with the Federal Government, and that principle we think is the same principle that should govern here.

That is, at the end of the day, Congress is required to do more than treat Federal judges on par with the vast majority of American citizens.

I do want to touch on the termination of violation point, which is, even if we're wrong about everything that I just said, it seems to me the only expectation that judges could have had when they took office was that their net pay would not have been reduced below the level at which they took office.

So the expectation... the expectation that judges had was not that they remain exempt from Social Security taxes in a kind of indefinite number that is just, they have an interest in an exemption, quia exemption, but a particular number has to be put on that, so if a violation did occur, the violation came to an end when Congress brought judges' net pay back up above the highest level that it had ever been at any earlier time.

If the Court has nothing further--

Justice Breyer: Well, yes, as long as you're at it, the part that was bothering me was not the part, treating judges the same.

It was the part of treating judges differently.

So what... I mean, they're treated differently in that everybody else is allowed to opt out but judges.

Now--

Mr. Wolfson: --Well--

Justice Breyer: --the reason is clear, I guess.

They weren't angry.

They didn't dislike our opinions.

It's just that they thought judges already have this pension plan, which is perfect.

That's why they did it.

But that only applied--

Mr. Wolfson: --It's not just that judges had the pension plan.

It's also that judges didn't have to pay anything and everybody else had to pay something.

All Federal employees also had to pay something, so they were not brought in mandatorily.

Thank you.

Chief Justice Rehnquist: Thank you, Mr. Wolfson.

The case is submitted.

Attribution:

The Oyez Project

Featured:

Gitlitz v. Commissioner - Oral Argument

Fri, 09 Jan 2009 14:50:33 +0000

Case:

Gitlitz v. Commissioner

Media File:

99-1295_20001002-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Darrell D. Hallett

Chief Justice Rehnquist: We will hear argument first this morning on number 99-1295 David A. Gitlitz versus the Commissioner of Internal Revenue.

Mr. Hallett.

Mr. Hallett: Mr. Chief Justice, may it please the Court, As a result of the position taken by the Commissioner of Internal Revenue on the brief before this Court, the issue the Court needs to decide is a limited one.

And that issue is whether the amount of debt discharge or cancellation of debt of an insolvent debtor which is excluded from income under Section 108 is income, such that it amounts to an item of income which increases the shareholder's stock basis under Sections 1366 and 1367 of the Internal Revenue Code.

The Commissioner rests his entire case in his brief on the argument that under Section 108 no income is realized by the insolvent debtor.

Your Honors, that position is clearly contrary to the statute.

And if I may rather than paraphrasing initially, read the statute, I think it's really critical to this issue and resolves this issue.

And that statute is section 108(a)(1) in the appendix to the petition, at Page 34.

And it states as follows, Gross income does not include any amount which, but for this subsection, would be includable in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs when the taxpayer is insolvent.

To paraphrase that, Your Honors, what that subsection (a) says in hopefully plain English is that an item is only excluded under Section 108 if it otherwise would have been included in gross income under Section 61.

Justice Kennedy: Well, I think your argument under the statute is a strong one.

But is there any reason in tax theory or practical equity why Congress would want to allow this result in this particular case?

I mean, I understand that the statute may compel this, but is there some underlying rationale to support your position?

Mr. Hallett: It may well be consistent with the restructuring of the Internal Revenue Code in 1954, in which Congress said very broadly in Section 61 that gross income includes all income from whatever source derived, and listed specific items, some 15 of those, and one of them is income from subsection 12.

And then consistent with that over in Sections 101 through 138, those items that are included in income are specifically excluded from gross income.

So--

Justice Kennedy: What I am asking is why would Congress allow you to use income that you don't pay tax on, to increase the basis and then which would allow you to deduct additional unrelated losses?

Mr. Hallett: --Well, first of all, because this statute clearly says that--

Justice Kennedy: I know that's position number one.

I'm asking, is there a reason for this?

Mr. Hallett: --There's a reason for it is that in the final analysis, the basis reflects the shareholder's equity in the corporation, roughly speaking, and the shareholder gets equity in the corporation by contributing capital.

He also gets equity in the corporation when income is realized, taxable or nontaxable.

And the Congress recognized that if losses have accumulated such that they are not deductible because they exceed the basis, well when income is realized, nontaxable income such as municipal bond interest, that income goes down to increase the basis to reflect the fact that there now is an increased equity investment.

Justice Ginsburg: Mr. Hallett, it seems that the Subchapter S shareholder is the only solvent entity who could take advantage of this.

The peculiar thing about this provision is that every other taxpayer, say a Subchapter C corporation, a partner in a partnership, the insolvent would have to be that entity, that tax paying entity.

But here you have the peculiarity that the Subchapter S corporation, which is not itself a taxpayer, is the insolvent, while the shareholders are highly solvent.

And is there any reason why Congress would want to give those solvent taxpayers this advantageous treatment?

Mr. Hallett: I think what... they clearly did that in 1984 when the Congress said that in the case of an S corporation, the amount is excluded if there's insolvency at the corporation level.

They certainly recognized that by doing that, the benefit of the exclusion would come down to the shareholder who could well be solvent.

And I think to the extent the legislative history reflects why they did that, it made it simpler to look to the insolvency of the corporation rather than up to 75 shareholders.

They may well have recognized that in any situation, certainly not all, if the S corporation is in trouble, the shareholder is in trouble as well.

Justice Ginsburg: But it wasn't that way up until... and yet, in 1982... well, let me put it this way, Do you recognize that if the 1982 law was still in place, the government should win?

Mr. Hallett: Well, it would depend on whether or not my clients the shareholders were insolvent.

If they were insolvent then they would be entitled to the result that we are seeking.

Justice Ginsburg: Yes, but in this case where we have very solvent shareholders and an insolvent Subchapter S corporation.

Mr. Hallett: This particular case, if the law would have remained as it was in 1982, then if the shareholder were solvent he would not be able to exclude the amount from gross income.

Justice Ginsburg: So it was the change in '84?

Mr. Hallett: It was a change in 1984.

Justice Ginsburg: And so we would look to a reason for that change if we are trying to understand, as Justice Kennedy asked, whether there might be something other than the words of the statute going for the position you are taking?

Mr. Hallett: That is true.

We would look to the change.

But I think you would also look to the critical statutes that existed prior to the change in 1984 and the statutes which provide for the basis increase, and those are Sections 1366 and 1367.

Now when Congress made the change in 1984, they did not change those provisions.

Justice Scalia: Mr. Hallett, is it invariably the case that this comes as a windfall to the solvent shareholder?

Would the government never recapture the benefit that the shareholder gets?

Mr. Hallett: Well, it's not the case that it's a windfall.

It's certainly not the case that it's a windfall.

Justice Scalia: Accept my characterization of it as a windfall.

Would any events in the future enable that benefit to the shareholder to be recaptured by the government?

Mr. Hallett: Well, certainly if you view a benefit excluding the debt discharge amount from gross income, then if the attribute deduction provisions come into play, you could view that as a recapture of the benefit in the future.

Justice Scalia: Well, suppose the corporation suddenly becomes solvent, its business picks up or in some new sort of business.

I assume that at that point the distortion would even out for years, say one, two, three, four and five, because the net operating losses which might otherwise have been deducted against the new income are now diminished by reason of the discharge of indebtedness income.

Mr. Hallett: That's correct.

Justice Kennedy: So there, to answer Justice Scalia's question, there might be, I think there might be some instances in which this distortion, if we can call it that, or windfall, does even itself out?

Mr. Hallett: That's correct.

And much as Your Honor stated, the increase in basis by the amount of discharged debt occurs at the time of the insolvency and permits the taking of the losses.

And by taking of the losses, the losses of course go away.

Justice Kennedy: So it isn't always a windfall or distortion, accepting those characterizations?

Mr. Hallett: It's not always a windfall.

Justice Souter: And I guess this was in Justice Kennedy's question.

The events that deny the windfall character will be in subsequent tax years; is that correct?

Mr. Hallett: That's correct.

That's correct.

Justice Scalia: Going back to your very initial point about Section 108, if Section 108 had read,

"items of income shall not include. "

instead of "gross income does not include", then the government would be right; is that correct?

Mr. Hallett: Well, I don't think so because it... it would still presuppose that the item is income.

In other words--

Justice Scalia: No.

I'm saying if it specifically said income from discharge of a debt shall not be treated as an item of income.

Mr. Hallett: --Yes.

Unknown Speaker: Then your whole case would collapse.

Mr. Hallett: Yes.

If Congress would have said specifically that COD is not income.

Justice Scalia: So it's the difference between excluding from gross income and specifically stating that it's not an item of income, as the case turns out.

Mr. Hallett: Exactly.

And that's a very important distinction that was drawn when Section 108 was enacted in 1980.

I'd also point out, Your Honor, that if the Commissioner were correct, that COD is not income, then Section 108 would never apply to an insolvent debtor.

And if we look at Section 108(b), it only comes into play if an amount is excluded under Section 108(a).

Now if it's not income and it's therefore, doesn't come within 108(a) because it otherwise wouldn't be income, then the attribute reduction process which the Commissioner places so much weight upon would never occur.

Justice Breyer: So what's supposed to happen?

Some disaster must occur in the tax code since the government did at one point push this argument, but it stopped, I want to know what disaster occurs if you just take 108(d)(7)(a), in which it says these things will apply at the corporate level.

It says it applies at the corporate level, those three sub... four subsections, (a), (b), (c) and (g); (c) and (g) are just special cases, but (a) and (b) is the main case.

It says they apply at the corporate level.

What does that mean?

It means it doesn't flow through.

It's very simple; nothing flows through.

The attributes don't flow through.

Nothing flows through.

All right.

Now once you say that, that cures what seems an anomaly from a point of view of policy.

Why don't we interpret it that way?

Mr. Hallett: Because the statute doesn't say that.

Justice Breyer: Well, let's see what it says.

It says, in the case of an S corporation, subsections (a), (b), (c) and (g) shall be applied at the corporate level.

Now why can I not take those words to mean they shall be applied at the corporate level and only the corporate level, i.e., they do not flow through?

Mr. Hallett: Because we have to look at what is applied at the corporate level.

For example, subsection (a), the exclusion from gross income is applied at the corporate level.

And that's logically because the corporation realizes the income and it excludes it.

Justice Breyer: Right.

Mr. Hallett: Subsection (b), and this is the critical part of the statute, an essential part of the statute as amended in 1984, is that the insolvency is determined at the corporate level.

But those two provisions do not say anything about the basis pass through.

Justice Breyer: I know they say nothing.

They say nothing.

So what I'm doing is suggesting that because they say nothing one way or the other, one can interpret those words

"shall be applied at the corporate level. "

to mean everything to do with 108 applies at the corporate level in the case of the Subchapter S corporation, and does not flow through.

So what I'm asking you is why can I not do that?

Mr. Hallett: Because the statute doesn't say everything occurs at the corporate level.

It says the gross income is excluded--

Justice Breyer: I've got that point.

Your point is the language.

Mr. Hallett: --Yes.

Justice Breyer: Is there anything other than the language?

Mr. Hallett: The plain language of the statute.

Justice Breyer: Nothing else.

Mr. Hallett: And the failure to say anything in either 108 or Sections 1366 and 67 about the general rule of basis... pass through to basis not occurring.

Unknown Speaker: So you're--

Mr. Hallett: There's nothing to suggest that.

Not a hint.

Justice Kennedy: --Is it an answer to Justice Breyer, and I may be wrong about this, that if that interpretation prevailed, there would be some instances in which the shareholder was really entitled to a double tax.

In other words, if there were basis left and the basis were not decreased as a result of this interpretation, then the shareholder in effect would be paying a double tax in some instances, or am I wrong about that?

Mr. Hallett: Well, I'm not sure it would result in a double tax.

I think it clearly would read into the Code language that's simply not there.

Justice Kennedy: Well, that the shareholder would be taxed in effect for discharge of indebtedness income even though the corporation was insolvent.

Mr. Hallett: That's true.

Justice Kennedy: Because the basis would not be reduced.

Mr. Hallett: That's true.

That's true.

Justice Ginsburg: Mr. Hallett, may I go back to an earlier colloquy, and that is, as I understand it in this case, the tax attributes, at least under your theory, they wouldn't... that would be an academic question because the losses here were entirely wiped out against the increased basis.

Isn't that right?

There were no losses left.

Mr. Hallett: True.

Once we go through the process of determining how much the losses exceeded basis for the taxable year, as the statute tells us to do, if the losses are completely absorbed by the COD, if they are completely absorbed because of the increase in basis, then assuming there's no other attribute, assuming there's no basis in assets that can be reduced, that would be true.

Justice Ginsburg: I take that to be the case here, that the losses were totally absorbed.

Mr. Hallett: No.

Actually, and I have to point out, this is not in the record, Your Honor, the losses were totally absorbed but there was some 800 thousand dollar basis in assets and properly applied, even though the losses were absorbed, the COD income is still there and the COD income would be applied in the next taxable year to reduce the basis in the assets.

Justice Ginsburg: But that's not... we don't have the next tax return before us, so we don't--

Mr. Hallett: No, no, that's true.

That's correct.

And I would just point out, it's a very important concept of Section 108 that, I think it's... you read the legislative history and it does admittedly talk about a purpose is to pick up the income in the future through the attribute reduction, but Congress allowed a very very important exception to that.

And that's the full ability to use net operating loss carryovers or basis in the case of property sold in the year of discharge.

Very very important, such that certainly many taxpayers are going to have excluded COD income but they are not going to have any attributes to be reduced.

I don't believe the situation we have here is in any way an anomaly.

We have absolute proof of that in one of the cases.

The Pugh case, there were no attributes at all.

There were no suspended losses, there was no basis in assets to reduce.

And the Court of Appeals of course held that the COD passed through.

So we know that situation.

We know that situation exists.

Justice Breyer: --Why do you say it's no anomaly?

I would think with an ordinary corporation the chance of an insolvent corporation ending up with a lot of positive income in the year of insolvency is pretty low.

With an individual, the chance of an individual ending up with a lot of positive income in the year of insolvency is pretty low.

In the case of an S corporation, the chance that a shareholder of the insolvent S corporation could have a lot of positive income in that year is pretty high.

And therefore, if we accept your intention for an S corporation, your interpretation, we reach as a practical matter quite a different result in terms of tax windfalls than you do in the other two instances.

Mr. Hallett: Well, I think though in the other two instances, take a corporation that's in trouble and has net operating losses, it could well be the situation that it doesn't have any basis in its assets in excess of the liabilities.

It excludes the amount from income and it doesn't have any attributes to reduce.

That's what I'm saying; it's not an anomaly to have a situation such as we have in this case that whether it's a corporation, a regular corporation or a partnership, that we don't end up with any attributes to reduce, particularly because they can be used in the taxable year of the discharge.

Justice Stevens: May I ask you a question about... nobody seems to discuss in the briefs about, 108(2)(e), which says, it seems to say in so many words, (e)(1), it says (e)?

You know what I'm talking about?

It's on page 36 of the appendix.

(b) says "reduction of tax attribute" and it lists the things that are reduced.

Mr. Hallett: Yes.

Unknown Speaker: And the last thing listed is the basis of the property of the taxpayer.

Mr. Hallett: Yes.

Unknown Speaker: Why doesn't that--

Mr. Hallett: Well, that could come into play if for example, if the taxpayer here had 800 thousand of basis in property, not the taxpayer, but if the S corporation had the 800 thousand dollar basis in property, then that would be reduced.

That would be reduced.

It would be reduced though specifically, Section 1017 says it would be reduced after the taxable year of the discharge, as of the beginning of that year.

I would just call the Court's attention as well to one other section that I think solidifies that income is realized as a result of debt discharge and that's Section 108(e)(1) on page 43.

And it specifically says there is no other insolvency exception to the general rule that COD is income to be included in gross income.

And that general rule is provided in Section 61(a)(12).

And finally on this matter, the Commissioner goes back to 1923 and cites court cases particularly in the depression era, and a Treasury regulation that was promulgated before the substantial 1980 revisions of Section 108.

And I would point out that those court cases are flawed reasoning.

The notion is that--

Chief Justice Rehnquist: --They are what, Mr. Hallett?

Mr. Hallett: --They represent flawed reasoning.

The rationale in those cases that if a debtor realizes debt discharge, that there is no income if he's insolvent.

Of course the Court held in 1931 in Kirby Lumber that as a general proposition there is income.

And these cases in the depression era picked up on some language in Kirby Lumber about

"the forgiveness of the debt frees up assets. "

And they said well, if you're insolvent, it doesn't add to assets.

And so there is no realization of income.

That was the rationale of those cases.

And I submit that just defies economic reality where a debtor has 2 million dollars in debt, or 1 million dollars in debt, or 100,000 dollars in debt, and that is discharged.

And if he's a few hundred dollars or a few hundred thousand dollars still insolvent after the discharge, that's a real economic benefit.

He can take the amount that otherwise would be paid for principal and interest on that debt and apply it to expenses to keep going.

When you recognize that the insolvency is determined based on the fair market value of the assets, it could well have a situation where the real estate operating assets, the value doesn't exceed the debts.

But when a million dollars of debt is discharged, that money is indeed freed up.

It does indeed free up the liquid assets to either pay down other debts or refinance or pay expenses.

If that rationale applied, if that rationale applied, that would mean where a debtor is insolvent and sells an asset for a million dollar gain, that... but is still insolvent, and say he takes the million dollars and uses it to pay off debt, if that rationale applied, there would be no income in that situation.

Because after the transaction, even though he's had gain, he's still insolvent.

That's not the tax law.

And I submit that that transaction cannot be meaningfully distinguished from the situation where the debt is directly discharged.

Let me turn briefly to the specific language of Sections 1366 and 1367.

And I think there's a question of where do you start here.

Do you start with Section 108 or do you start with Sections 1366 and 67?

I don't think it makes a difference.

Because if you start with Section 108, you go to 108(d)(7)(b).

And that sends you over to Sections 1366 and Sections 1367.

Sends you over to determine the amount of the losses that are disallowed for the taxable year of the discharge before you can determine that there is an attribute.

And those, I would just point out that 1366 and 67 are very, very broad.

This isn't a narrowly drawn statute.

It says in 1366 that all items of income, including tax exempt income, are taken into account in determining shareholder basis.

Congress described the reason for the basis increase in some of the legislative history as insuring that if an item is nontaxable, then if there's later a distribution, the shareholder doesn't have to recognize income as a result of the... it preserves its nontaxability.

The Commissioner seizes upon this stated purpose of a shareholder basis increase and argues that, well, that means that you only could increase basis for a nontaxable item if you get cash, money in the till that you can distribute in kind.

Well, the statutes don't require that there be a distribution in kind.

The statutes don't say that you have to lock the cash up in a safe deposit box and use it in the future for a distribution.

The fact is if you have municipal bond interest that's collected and used to pay debt you are in the same situation on the bottom line balance sheet situation of the shareholder and the corporation.

But the critical event here, and this is... I'm glad the Commissioner brought up this notion of realization of income, because commentators and some of the courts have said that, well, you shouldn't give the shareholder the losses because he hasn't had an economic loss.

Well, the point is, he's had an economic gain.

It's the economic gain, the income, that Congress has chosen not to tax, that permits the taking of the losses.

I would finally point out under Section 108 that... excuse me; before I get to that I would point out that what we are asking for is consistent treatment here.

An S corporation that gets excludable municipal bond interest is entitled to up the basis and take losses.

And we ask for the same thing.

The... all other debtors who exclude COD income get to use their attributes in the year of discharge and we ask for the same thing.

And this 108(d)(7)(b) has really been a matter of confusion.

It hasn't been read closely.

It requires that before you eliminate any losses you have to go over to Sections 1366 and 67 and determine if there is an excess of losses remaining after the COD income is taken into account.

I will reserve the remainder of my time for rebuttal.

Argument of Kent L. Jones

Chief Justice Rehnquist: Thank you, Mr. Hallett.

Mr. Jones, we'll hear from you.

Mr. Jones: Mr. Chief Justice, and may it please the Court.

Congress did not provide to Subchapter S shareholders the unique double tax benefit that petitioners seek.

The simple question presented here is whether the discharge of debt of an insolvent is an item of income or tax exempt income that flows through to shareholders and increases their basis under 1366.

The plain text of the directly applicable statutes seems to provide a pretty clear answer to that.

Justice Ginsburg: Mr. Jones, would you clarify whether you are indeed walking away from the rationale of the Tenth Circuit which was not about the characterization of this as income, but was a timing question, as I understand it.

Mr. Jones: The timing question, we don't think the timing question ever arises in this case, nor has it ever properly arisen in any of the other cases.

Justice Ginsburg: But you did argue the theory that the Tenth Circuit accepted; you argued it in the Court of Appeals.

Mr. Jones: Actually, I believe the Tenth Circuit developed that theory on its own.

I believe that in the Tenth Circuit as in the other cases our argument has been twofold, that this item has never been regarded in the 80-year history of the Internal Revenue Code as income for an insolvent taxpayer.

Secondly, that 108(d)(7) recognizes and is an emanation of that fact.

The Tax Court rationale was that 108(d)(7) says all of this happens at the corporate level.

And it isn't income because it's excluded and it's not tax exempt income so nothing passes through.

Justice Kennedy: To put Justice Ginsburg's question another way, if you do not prevail on your argument that it's not income, I take it you don't ask us to accept a backup position that reflects the view of the Circuit on timing.

Mr. Jones: If the Court were to disagree with our basic contentions, then you would be faced with a problem... then as a Court the problem would be that you have the clear history of the statute that says this is not to be treated as income.

It's to be applied against tax attributes and then to be disregarded.

So you would have that clear history.

You would also have the presumptive rule that tax statutes should not be interpreted to provide a double benefit.

Justice Kennedy: No, we don't think it's a problem.

Let's assume that we simply reject that argument.

I want to know if the backup argument, if you think that as a matter of sound, statutory construction, I think this is what Justice Ginsburg was asking, for us to accept the timing rule adopted by the Circuit.

Mr. Jones: It is an appropriate resolution of the problem if you reach it, and the reason that is so, is that 1336(d)(2) requires the losses, the suspended losses from the prior year, to be brought into the corporation in the year of the discharge.

And then--

Justice Kennedy: 1336 or 66?

Mr. Jones: --1366(d)(2).

Chief Justice Rehnquist: Now Mr. Jones, we've got some 20 pages in the appendix of statutory sections.

When you cite a statutory section, could you refer us to the page of the appendix on which it is?

Mr. Jones: On Page 53 of the petition appendix.

It says, any loss or deduction which is disallowed for a taxable year by reason of the prior paragraph of that same page, shall be treated as incurred by the corporation in the succeeding taxable year.

Now this is the point that the Tenth Circuit made, that this provision brings back into the year of the discharge the losses from the prior year, the suspended losses from the prior year.

And then--

Justice Ginsburg: But Mr. Jones, isn't that antithetical to the... is it in 1017 the general timing rule that you take this in the next year, not in the year of the--

Mr. Jones: --It is a different treatment of suspended losses.

It is expressly a different treatment of suspended losses and how they are handled on the Subchapter S return.

These are rules peculiar to Subchapter S's.

Yes.

The answer to your question is yes.

It is a different treatment for suspended losses.

It brings them into the year of the discharge.

And then under 108 we know that the tax attribute reduction is to apply at the corporate level.

Justice Ginsburg: --If you think that the timing rule is changed here, it's surprising that you didn't make any suggestion of that in your brief.

Mr. Jones: Well, I think that it's... I wouldn't call it a fall back argument but I would call it not a correct way to analyze the basic problem that we have in this case, which is that the courts have glossed over the question of whether this has ever been regarded as an item of income, and in particular whether Congress intended it to be treated as such, when the history of the statute says as clearly as it could that Congress accepted the 80 year old position of the Treasury and the judicial insolvency exception, did not regard this as an item of income, said that it was to be applied to reduce tax attributes and then in the words of both the House and Senate reports, has no further tax consequences.

Justice Ginsburg: Let me see if I can get you to focus precisely on the point I'm trying to understand.

You have just told us that in the Tenth Circuit brief we will not have found this unusual approach to the timing question.

We would not have found that in the government's argument.

We certainly don't find it in our brief in this Court.

I'm just trying to determine whether the government at least considered it an alternate argument in the lower courts and for some reason abandoned it here.

Mr. Jones: I think it... I wouldn't quite put it that way.

I think that the right way to put it is the way I have put it, which is that with proper... we are presenting this case to you with complete integrity.

We think this issue need not be reached in this case.

Unknown Speaker: Did you present it the same way in the Tenth Circuit?

Mr. Jones: Actually, I believe in the Tenth Circuit we didn't address the issue.

I believe the Tenth Circuit developed its analysis on its own.

Justice Ginsburg: So if I look at the government's brief, I'll find that corroborated?

Mr. Jones: I think that's correct.

Justice Kennedy: Did you address the issue you are now addressing in the Tenth Circuit?

Mr. Jones: I'm sorry, Justice?

Justice Kennedy: Did you address the issue you're presenting to us in the Tenth Circuit other than--

Mr. Jones: Yes.

Justice Kennedy: --in footnote 14 of your brief.

Mr. Jones: Although in the Tenth Circuit, we were defending the tax court's ruling.

Justice Kennedy: Yes, but for whatever reason, this argument that you now say is so obvious on the face of the Code, was this referred to in your argument to the Tenth Circuit other than in a footnote, footnote 14 of your brief?

Mr. Jones: Well, you are expressing a close familiarity with that and I don't remember footnote 14.

Justice Kennedy: I didn't dig this out myself.

It was stated in your opponent's presentation.

Is it inaccurate?

Mr. Jones: It is... I have recently looked at our brief in the Tenth Circuit and my recollection of our brief in the Tenth Circuit was that we made the same point and we made the same argument in the context that the tax court resolved the issue, which is that first they talked about how it's all done at the corporate level.

And then having reached that conclusion, emphasized that there is no item of income and no tax exempt income in connection with this item.

Justice Kennedy: This does not constitute income.

You made that explicit argument?

Mr. Jones: Yes.

In fact, we noted that the Treasury regulations have provided this for 70 years, long before 61 was enacted, long before 108, and that the courts had adopted the judicial insolvency exception, had agreed with the Commissioner that no income arises from the discharge of the debt of the insolvent.

Justice Kennedy: Are there past cases in which the IRS has argued that something is not income, or is this a first?

Mr. Jones: Well, it's an uncomfortable position for us.

I mean, I would love to be able to resolve this case properly without addressing that subject.

But we can't because Congress made that the fulcrum of its legislative determination.

Justice O'Connor: You know, it seems a little contradictory to say that under Section 108, the taxpayers here have to pay some sort of tax whether you call it a deferred tax or just a price on something that you say isn't income of any type.

It just seems contradictory.

And I'm concerned, if we say it's not income, that there may be other items that are currently considered to fall within section 61 as income that all of a sudden we find aren't.

And I don't know how far that would take us if we--

Mr. Jones: I don't know of any other.

And of course I don't know if that provides you with any comfort, but let me answer the first part of the question you raised which is, are there other situations where something that does not constitute income has an effect on basis, or doesn't.

The closest example, and I don't believe it's quoted in the appendix, is 1368(b).

And 1368(b) is a provision that says that if a Subchapter S corporation has no earnings and profits and makes a distribution to its shareholder, that won't be treated as income and under 1367 it will reduce their basis.

Well, this is a similar determination.

If something has happened here that puts the shareholders in a position whether they might--

Justice Scalia: --Excuse me.

That means it won't be treated as income to the shareholder.

Mr. Jones: --Yes.

Justice Scalia: You are not talking about whether in the abstract it's an item of income.

They have to say that it's not treated as an item of income because otherwise it normally would be.

Mr. Jones: Well, actually, if you look at the close words of the statute, it doesn't say that.

Section 61 begins with the phrase

"except as otherwise provided, discharge of a debt is an... is income, section 108 says, discharge of a debt of an insolvent is not an item of income. "

And that recognizes the historical distinction that Justice... that this Court had talked about in Commissioner versus Tufts, in Justice Blackmun's opinion that the whole theory of the discharge of indebtedness doctrine is that the discharge frees up the assets of the debtors and he could use them to--

Justice Ginsburg: May we go back to the formulation that gross income does not include?

Well, that same formulation is also used for tax exempt bond interest.

Mr. Jones: --Yes.

Unknown Speaker: For life insurance proceeds, and even though it says the same exact words, does not... gross income does not include, we know that those do up the basis.

Mr. Jones: Not as an item of income though.

They come in as tax exempt income.

1366 raises the basis for items of income including tax exempt income.

Tax exempt income is something that really is income, and it's an accretion to wealth.

The only example that--

Justice Ginsburg: But the words of the statute are the same.

Gross income does not include.

Mr. Jones: --Right.

But tax exempt income is real income.

It's something that you receive.

It's an asset.

It is an accretion to wealth within the concept of--

Justice Ginsburg: And forgiveness of indebtedness--

Mr. Jones: --Is not.

Forgiveness of indebtedness for an insolvent, as Justice Blackmun pointed out in footnote 11 of Commissioner versus Tufts, doesn't free up any assets.

Justice Kennedy: --But that was addressed by your adversary.

He said well, suppose you have a corporation which is insolvent by a million dollars, and part of that is a 950,000 dollar indebtedness.

There's a world of difference.

It amazes me that the government says this isn't income.

Justice Scalia: Or to put it more simply, if my bank told me, you know, forget about your mortgage.

Boy, I'd feel a lot richer.

You are telling me that that is not an accretion of wealth?

That's unbelievable.

Mr. Jones: My responsibility to this Court is to tell you how Congress, what we understand Congress used these terms to mean.

Congress could not have been more clear.

They adopted a judicial insolvency exception that adopted a longstanding regulatory interpretation.

It doesn't matter, this Court doesn't have to resolve the broader question of whether under Commissioner versus Glenshaw Glass this might be thought to be an accretion of wealth.

You don't have to resolve this question because what is before the court is how did Congress view that difference.

Justice Breyer: Given that is before the Court, what was your answer to Justice Ginsburg.

I was having exactly the same problem.

I accept its a loophole, for argument's sake.

If it was a terrible loophole, this would not be the first loophole that Congress wrote and it won't be the last.

And maybe it would be the last, marvelous.

There are 31 separate... 29 separate subsections of this statute that use the words "gross income does not include".

And I take it in respect to every one of those but one, you will say they are items of income.

And obviously one thing I would be reluctant to do is to take those same words "gross income does not include", and say that those are items of income in every instance but this one.

Or in every instance but three.

Or create a new spider web of rules as to when the words "gross income does not include" does mean it is none the less items of income but doesn't in other.

That's the problem I'm facing.

And to say "it's Congress's clear intent" doesn't help me solve that problem.

Mr. Jones: But it should help you resolve that problem because what's at issue was what was Congress's intent when it used the phrase "items of income".

Justice Breyer: And are you saying it's always the same, those words 29 subsections whatever they are referring to is never an item of income or do you mean sometimes is and sometimes isn't?

Mr. Jones: I think I'm focused on your problem.

I think the answer to your question is probably that in all of those instances it wouldn't be an item of income.

Justice Breyer: Never?

What for example about a lessor's income?

There's a reference here to a payment by a lessor of a certain kind of rent which I thought surely would increase basis.

Mr. Jones: It wouldn't be income received in the year.

And what happens is you are supposed to reduce the basis and recognize as this Court said in Centennial Bank, recognize that deferred income in future years.

And as that's recognized then it becomes an item of income in that sense.

But in the first year it's not treated as an item of income for this purpose.

Justice Scalia: Then it's income when it hurts the taxpayer in later years?

Mr. Jones: It's income... if it's income then it increases the basis.

And if its not income, it doesn't.

And if its not income and doesn't increase the basis then it's... then any income effect would be recognized in subsequent periods.

Justice Breyer: Could you answer one other question which is,... but it's going to sound as if it's on your side so be tempted to agree but don't agree because you haven't pushed this argument and I want to know why.

It seemed to me that the strongest point was the words keeping it at the corporate level.

Because if you kept it at the corporate level no problem I can think of would be caused and it eliminate the loophole and seems consistent with the language, but you have not pushed that argument.

And therefore there must be some disaster in tax law lurking.

Mr. Jones: We do.

We put it as our second point.

We don't abandon that argument.

It's definitely addressed in our brief.

Its sort of an intellectual fussiness that causes us to address the income issue first and then the shareholder issue, I mean the corporate level issue.

And that is because (d)(7) wasn't enacted, as Justice Ginsburg pointed out until 1984.

But in 1980 Congress already went ahead and said this is not to be treated as an item of income; it's to be used to reduce attributes and it is to have no further tax consequences.

So we shouldn't have to look to 1984 legislation in (d)(7) to answer this question.

Now (d)(7) is consistent with our answer and therefore and it is a sufficient answer.

But it seems to me to be perfectly faithful to what Congress said they did and to what the text of the these statutes permit us to understand.

We don't have to go to 84.

We can go right to where Congress said.

And I want to point out in this respect that it is solely on the 1980 legislation that professors Victor and Lokin reviewed the history, reviewed the provisions and agreed with us that the discharge of indebtedness of an insolvent party does not represent an item of income and is to be ignored after it's applied against the tax attributes.

Now what Petitioners' is, let's not ignore it, let's get a tax benefit from it.

We'll pass it through as if it were income.

We will get a basis adjustment that allows us to deduct the standard losses.

And what they have done is used 108 to enhance their tax attributes when section 108(b) makes it clear that the whole point of 108(b) is to reduce tax attributes.

Justice Ginsburg: What do you think Congress did then in '84?

I take it that taxpayer is conceding that if the 82 law remained in place a Subchapter S shareholder would be just like a partner in partnership and could not get this benefit?

Mr. Jones: Well that--

Justice Ginsburg: But there was a change in 108, and it seemed to me that what you were essentially arguing is that we should undo the change that Congress made in 108.

And you are telling me, no, the change in 108 didn't do anything?

Or what?

Mr. Jones: --It didn't change the basic principles of 108 that the amendment in 1984 simply said that the tax attribute reduction would be applied at the corporate level for Subchapter S corporations.

This is in 108(d)(7)(a).

Justice Ginsburg: If they applied at the shareholder level then you have a solvent shareholder.

Mr. Jones: If they applied it at the shareholder level for solvent shareholders they would recognize the income and pay it on their own returns.

It wouldn't have any consequence.

Justice Ginsburg: Right.

But what was the effect of saying take it at the corporate level so that the insolvent is the corporation?

Mr. Jones: Congress said that they were doing that because they wanted all shareholders to be treated the same.

That was the explanation that Congress gave.

Justice Ginsburg: Well, didn't somebody point out to Congress or didn't Congress know that a Subchapter S corporation is quite different from a Subchapter C corporation?

Mr. Jones: Well, this is a special rule actually that applies only for Subchapter S's.

Justice Ginsburg: But you just me the rationale was that all corporations should be treated alike.

Mr. Jones: No, no, no, I'm sorry, that all shareholders of this Subchapter S corporation should be treated the same.

In other words they didn't want to... Congress said they didn't want to have shareholder one to be treated differently from shareholder two although as you are aware for partnerships that kind of different treatment can result.

But Congress didn't think this had anything to do with... that the change in 108(d)(7) had anything to do with the issue here because they had already resolved the issue in 1980 when they explained how these statutes were to work.

And I want to point out that in 1993 when Congress amended Section 108 to extend its application to qualified real property indebtedness, Congress went through the operation of these same provisions and said the same thing.

Justice Ginsburg: But Congress was explicit there in a way it isn't here.

Mr. Jones: I don't know how Congress could have been more explicit in 1980--

Justice Ginsburg: Didn't Congress say that there won't be any increase in basis?

Mr. Jones: --That's true That was explicit in '93.

Justice Ginsburg: And here we don't have anything that says it won't be an increase in basis.

Mr. Jones: We have awfully good indication of that.

We have Congress saying it's not income.

It's only to be used to reduce tax attributes.

It has no other tax consequences, and is then to be disregarded.

Justice Ginsburg: But you will concede that to say basis will not be increased is something a lot clearer than what you are presenting to us?

Mr. Jones: Yes, it's perfectly clear.

But to me it's--

Justice Ginsburg: So why didn't they make that same statement with respect to this, knowing that the courts were all over the lot?

Mr. Jones: --In 1980 the courts were not all over the lot.

In 1980 no court had ever suggested that the discharge of the debt of an insolvent was income.

Justice Ginsburg: What was the year of the real estate provision?

Mr. Jones: 93.

Justice Ginsburg: 93.

Mr. Jones: Yes.

Justice Ginsburg: So I am asking about when they made that change in 93 and they said basis will not be increased.

Why didn't they just say, well, let's do the same thing for subchapter S corporations?

Mr. Jones: I am sorry.

They were talking about Subchapter S corporations in 1993.

They were talking about exactly the issue we have in this case.

Justice Ginsburg: But I'm just simply asking you why didn't they make that same change to say explicitly basis will not be increased, since that would have cured--

Mr. Jones: The statute wasn't amended in any of its substantive characters in 93.

They just added another provision to the same statute--

Justice Ginsburg: --Yes, but couldn't they have said

"now we are adding this provision. "

"And we are making this thing explicit. "

"To make the statute compatible we ought to make that same provision elsewhere. "

Mr. Jones: --They were talking about,... When they said basis is not adjusted, they were talking about the Subchapter S corporation provisions involved in this case.

So they were talking about previously enacted provisions of Section 108 in describing how they applied.

Justice Ginsburg: There are certain words that are used.

Mr. Jones: Basis is not increased by--

Justice Ginsburg: Yes.

And why wasn't it made clear then?

Basis is not increased, with respect to this subchapter S?

Mr. Jones: --That is exactly what they said at that the time in '93.

I'm sorry.

We are not communicating.

Justice Ginsburg: No, we are not.

We have a provision that says those words expressly.

You are asking them--

Mr. Jones: It's not a provision.

It's just legislative history.

Justice Ginsburg: --I thought it was in the statute itself.

Mr. Jones: No, I am sorry.

Now I understand.

It was in the history of--

Justice Ginsburg: Its not in the statute itself in any case?

Mr. Jones: --It was in the history of the 93 amendment that Congress in going through how the statute operates, explained that for subchapter S corporations this is not an item of income; it doesn't adjust basis.

That is all I am saying.

I am not saying that this is binding history, I'm just saying it is.

Justice Ginsburg: Is there a provision of the Internal Revenue Code that says basis will not be increased that was a change that was made in the statute, not legislative history?

Mr. Jones: I am not familiar with that, but it is just the contrary.

The statute says only that basis will be adjusted if there's an item of income.

An Congress said this isn't and item of income.

I know that that's--

Justice Ginsburg: Perhaps I will look for it.

It's that real estate... I am sure that you must be familiar with it and I thought that in that statute itself those words appeared.

Mr. Jones: --I am not familiar with that.

The contention that if it is not an item of income then its tax exempt income is also fundamentally flawed for the same reason.

Its not tax exempt income because its not an accretion to wealth.

Its not income in the first place, tax exempt income.

Justice O'Connor: Except that Section 61 of Title 26 says that income includes income from discharge of indebtedness.

I mean that's a germinal provision.

Mr. Jones: It says "Except as otherwise provided #"--

Justice O'Connor: Yes.

Mr. Jones: --Income includes income from discharge--

Justice O'Connor: So that is the normal rule.

Mr. Jones: --Well, that's the contingent rule.

It says except as otherwise provided, income includes income from discharge.

108 says it does not include income from discharge of an insolvent.

And that is the 80 year history of the Internal Revenue Code.

Justice Scalia: And it also says it does not include income from a lot of other things.

I mean, as Justice Breyer was pointing out earlier, there are a lot of other things as to which it says the same thing.

And all it means is that although gross income would normally mean this, for purposes of subchapter S, it will not mean that.

But that does not mean... it is in the abstract, not income.

I thought the argument you are making here--

Mr. Jones: I don't have any objection to what you just said.

I think it is perfection correct.

I think it's a proper concern.

But our point is that what you are supposed to, what we have to resolve here is what did Congress mean when it said items of income in 1366 because that's what flows through.

Congress said this is not an item of income.

And I say this, I mean the discharge of the debt of an insolvent.

My only point about the congruence of 61 and 108 is that they cannot win on those provision because all those provision say is what we say, It's not income.

And what the legislative history of the provisions say is exactly... is why we are here today, which is that Congress has always said this isn't income.

Has never permitted it to have any tax consequences other than attribute reduction.

And I go back again to Victor and Loken.

I mean, they are a pretty objective neutral source on this, and they agree with us, that this is not the way Congress used the term and that after it is used to reduce attributes, it's to be ignored.

The reason.

Chief Justice Rehnquist: --Was this some article in a law review you are talking about.

Mr. Jones: It's actually in their treatise.

Chief Justice Rehnquist: In a treatise?

Mr. Jones: Federal Income Taxation.

It is a pretty reliable guide.

Chief Justice Rehnquist: How has the Court of Appeals come out on this issue?

Mr. Jones: The Court of Appeals have been sort of all over the map.

If you are talking about the Court in this case,--

Chief Justice Rehnquist: No, I meant just the Court of Appeals.

The Court or Appeals ruled for the government on this issue.

Mr. Jones: --Yes.

Chief Justice Rehnquist: Have other Court of Appeals ruled against the government on this point?

Mr. Jones: Yes, The Third Circuit in the Farley case ruled against the United States, saying that the plain language of 108 makes this an item of income.

And I don't understand their reasoning because the plain language of 108 says it is not an item of income.

And the clear history of the statute says it should never be treated as one.

And instead it is to be ignored after you reduce basis.

I mean after you reduce the tax attributes, So.

Justice Scalia: In fact, no Court of Appeals has agreed with the government on this point, has it?

Is there any Court of Appeals that has agreed with this argument?

Mr. Jones: I don't think there is a Court of Appeals that has gone through these arguments that we have made the primary focus of our position in this court.

Justice Scalia: The answer is no.

Mr. Jones: They haven't addressed them, Justice Scalia.

Chief Justice Rehnquist: Why didn't the government argue this in the other courts?

Mr. Jones: Again, I believe what we were doing is that we were forwarding the rationale... we were defending the rationale of the Tax Court.

Chief Justice Rehnquist: Which you now disagree with?

Mr. Jones: As I explained to Justice Breyer, we think that the proper way to reach this, to analyze this is the way Congress did, to start with 108 in 1980.

And then to point out that the amendment to (d)(7) in 1984 was consistent with that result and promoted that conclusion.

Now, what the Tax Court did was different.

They said, as Justice Breyer points out that all of this should be done at the corporate level and nothing escapes to the shareholders because it's all handled at the corporate level.

I think that's a correct conclusion.

But I think one of the reasons it's a correct conclusion is because there is no item of income that can escape to the shareholders and add to their basis and give them this double tax benefit wind fall.

And I do want to point out that in each of these cases when a basis adjustment is allowed there is indeed a windfall there.

Chief Justice Rehnquist: But that can't be controlling.

There's no reason to simply distort the tax code to avoid a wind fall in this particular case.

Mr. Jones: I don't its controlling but it is a presumption that Congress doesn't intend to do that.

And so when you look at these statutes and you have the clear history, and if you have any uncertainty about the application of the plain text of those provisions, that uncertainty should be resolved to avoid creating... either denying the intention of Congress or creating the windfall benefits.

Justice Scalia: Let's assume the insolvent corporation... I'm sorry.

What's the presumption you refer to.

Mr. Jones: The presumption is what this Court said in Skelly Oil, that tax statutes should not be interpreted to be provide the practical equivalent of a double deduction, which is exactly what they have sought.

Justice Scalia: Could it not end up being a double tax in the other direction?

Let's assume an insolvent chapter S corporation that later recovers.

All right.

The taxpayer would never have gotten the increase of his basis that arises from this reduction of indebtedness and therefore could not offset against any future gain that he gets from the corporation.

Is that fair?

Mr. Jones: I think that what you are pointing out is exactly the opposite of how Congress looked this situation.

What Congress said was they are getting this immediate benefit not having this treated as income in the year that the debt is discharged.

And recognize that they might benefit from that in future periods if they have income from other sources, Congress said I want to reduce the tax attributes, the favorable tax attributes, like suspended losses--

Rebuttal of Darrell D. Hallett

Chief Justice Rehnquist: Than you, Mr. Jones.

Mr. Hallett, you have two plus minutes.

Mr. Hallett: With respect to Victor and Eustice Treatise, what it actually says is that COD income of an insolvent debtor is not gross income.

And it's cited in the brief.

Not one of the authorities cited by the government say that it is not realized.

They say it's excluded from gross income.

With respect to... if the Commissioner were right that because an item is excluded from gross income, then none of the items excluded from gross income, life insurance proceeds, interest on municipal bonds, none of those would increase basis because they are not income and could not be an item of income.

This double tax benefit.

There is no tax benefit at all without a basis increase.

The item just as well have been taxable.

If it was taxable, the income would flow down to the shareholder.

His basis would go up and he'd be able to his loss against the income.

He'd end up with zero basis and zero income just the same position where the Commissioner urges he should end up here.

Finally the Tenth Circuit did not develop the timing rule on its own.

That rule is word for word what was urged upon it by the Justice Department in that case.

This case has been a constant moving target.

The only time the Commissioner argued the no realization was the first time this case was decided before then Chief Judge Cohen in Tax Court.

She rejected it.

It was never raised again until it was raised in the petition for certiorari in this brief.

I submit, Your Honor, a plea on behalf of tax practitioners in this country.

They should be able to read the Code as written.

They shouldn't have to speculate as to whether or not a result that is called for on the plain language of the statute is too good to be true or is a wind fall.

The tax laws are too complicated to have to get into that kind of speculation.

Thank you.

Chief Justice Rehnquist: Thank you, Mr. Hallett. The case is submitted.

Attribution:

The Oyez Project

Featured:

Baral v. United States - Oral Argument

Fri, 09 Jan 2009 14:50:17 +0000

Case:

Baral v. United States

Media File:

98-1667_20000118-argument.mp3

Related Transcript:

1999_98_1667_argument.xml

Transcript:

Argument of Walter J. Rockler

Chief Justice Rehnquist: We'll hear argument first this morning in No. 98-1667, David Baral v. the United States.

Mr. Rockler.

Mr. Rockler: Mr. Chief Justice, and may it please the Court:

This case involves a claim for overpayment of income tax for the calendar year 1988.

There is no question of the overpayment.

It occurred and is acknowledged.

The taxpayer's claim was filed June 1, 1993 on Mr. Baral's income tax return which was filed late.

Nevertheless, there is no dispute that the claim of overpayment was timely for code section 6511(a) purposes.

The question of a limitations bar to recovery arises under code section 6511(b), which provides that only payment of tax sought to be refunded, made within 3 years before the claim, may be recovered.

It's 3 years plus any extension of time granted to file a return.

Justice Scalia: 4 months here?

Mr. Rockler: 4 months in this case, yes.

If the starting date for limitations... if the starting date for limitations is April 15, 1989, the payments could not be recovered.

The starting date is June 1, 1993.

The statute of limitations does not apply.

The limitations period under section 6511(b) starts running from the date of payment of the income tax, not from the date that income tax liability arose or accrued.

In the Government's view and that of the court of appeals below, the payment of income tax was made April 15, 1989, the income tax return due date, although on that date, the amount of income tax liability had not been determined and was not known by anyone.

The Government and the court below assert that section 6513(b)... (b)(1) and (2)... makes the return due date the starting date for limitations, quote, as a matter of law.

In other words, they assert that deemed due date of the return was the date of payment of the income tax.

In our view this is a misreading of the statute.

The statute provides that the... the deemed date, the date of the return being due, is the date to which withholding taxes and estimated taxes are brought forward instead of their actual payment dates which occurred during the calendar year.

Justice O'Connor: But the statute reads as though estimated tax payments are prepaid income taxes.

They are deemed to be prepaid income taxes.

Mr. Rockler: No, I don't think the... I don't think the section says that, Justice O'Connor.

I think it's a... if I may refer to the section itself.

That is section 6513(b)(2).

Chief Justice Rehnquist: Where will we find that, Mr. Rockler, in the brief?

Mr. Rockler: It's at the end of both briefs.

In our principal brief, it's at page A-12, appendix page 12.

That says, any amount paid as estimated income tax for any taxable year... I repeat estimated income tax... shall be deemed to have been paid on the last day prescribed for filing the return under section 6012 for such taxable year, determined without regard to any extension.

The deemed date is the date of payment of the estimated tax.

Now, the court in considering this, at least those courts that have been adverse to our position, have without any focus simply assumed that the deemed date of payment of the estimated tax is the deemed date for payment of the income tax.

And those are two totally different things.

An estimate is just what it claims to be.

If I may digress for a moment and refer to the Rosenman case, which has been featured heavily in the briefs here.

In that case, the remittance was...

Justice Stevens: May... may I interrupt you, Mr. Rockler, for just a second?

Why would the Congress want to draw a distinction?

What is the significance of deeming a date for the payment of the estimated tax other than to establish the date of payment of the tax itself?

Mr. Rockler: No, no.

There... if I may say so, Justice Stevens, the statute which originally brought this into the code, the 1943 tax act, made the point that the deemed date was the deemed date, but not earlier than the deemed date.

In other words, that phrase appeared.

It got dropped in the '54 code.

But the significance I think is that you have cases not unusual at all, where taxpayers file a return early between December 31 and the due date of the return, and the... that... that filing of a return and bringing across the credits for withholding and estimated taxes against the income tax would start the statute of limitations running before the return date.

It also would start interest running before the return date.

And I think the real function was to limit the application of the statute to not earlier than a return filed on the due date...

Justice Ginsburg: But that language...

Mr. Rockler: and to... and to limit the payment of interest to that date.

Justice Ginsburg: Mr. Rockler, you... you recognize, Mr. Rockler, that that language was dropped.

And also starting from the '39 code, the word was may and then it... not earlier than, and now the word is shall be.

And the caption of 6513(b) is prepaid income tax.

So, at least the caption, although it may not have the force of law, at least the caption, prepaid income tax, and the word shall seem to tug against the position you're taking.

Mr. Rockler: As to the caption, first, I think that is a... a secondary or tertiary form of reading the... the statute.

I think the words of the statute itself are of more consequence.

But the word prepaid income tax can also be viewed as a synonym for advanced payment of income tax, in other words, can refer to a credit situation.

Let me refer the Court to section 6611 of the code, which is cited in the briefs.

It makes plain in two sections on interest...

Chief Justice Rehnquist: And where will we find this, Mr. Rockler?

Mr. Rockler: I think it's cited in the Government's brief.

It is cited.

I'm not sure it's reproduced in the briefs.

Chief Justice Rehnquist: If you were going to rely on it, I would have thought it would be a good idea to reproduce it.

Mr. Rockler: I regret, Your Honor... Mr. Chief Justice, that I don't think it is in the briefs.

But that has two subsections, one of which deals with late return filing.

It says, interest shall not be paid until the return is filed.

Then it has another subsection entitled advanced payments, withholding taxes, and estimated taxes, and that, in effect, deals with early payments and says interest won't be paid until the due date at the earliest.

In effect, it repeats what was said pretty much in the '43 act.

Now, one reason why we've referred to the '43 act is the Government has cited that act, I think without any great effect, as controlling with respect to the purpose for which this was adopted.

Incidentally, I may say, in response to Justice Ginsburg's comments, that the Habig case, which we have cited in the brief... that's 390 U.S. at page 225... deals with section 6513(a).

The sections immediately involved here are 6513(b).

But that also has a deemed due date as the date for the presumable starting point of the statute of limitations.

And in that case, the Court makes it very clear that that is designed for the purposes which I ascribed to 6513(b), namely not to start the statute before the return due date, not to start interest payments before the due date.

Justice Ginsburg: Mr. Rockler, the Habig case was about, was... was it not, filing a false tax return?

So, it seems to be quite far afield from this case.

Mr. Rockler: Oh, it is not... it is not directly on point for this case.

We... we cited that case primarily for the point that impossibility may override the application of the statute.

In that case, there was a criminal case and a statute of limitations of 6 years.

And the question was, did the statute start on the return due date or the actual filing of the return?

And the Court held it had to be the actual filing because the offense was to be found in the return filed.

How could you have a statute of limitations running before the offense occurred?

Similarly, in our situation, our position basically is, how can you have the payment of a tax when nobody knows what it is?

And I might remind the Court that long ago this Court held that to be the governing principle here.

That's... that's the Rosenman case, and the Rosenman case is very central to your consideration, I think, of this situation.

The Rosenman case was very close to this case in many respects.

There the taxpayer, a month or so before he filed a return, sent in a letter saying that he was paying an estimated tax, which is involved here as well, for the purpose of avoiding penalties and interest.

And the Court said at the time he remitted the estimate of estate tax there, he couldn't be paying the estate tax because nobody knew what the estate tax was at that time.

Chief Justice Rehnquist: But... but Rosenman too, Mr. Rockler, involved a rather express agreement by the Government, did it not, to kind of hold this in escrow?

Mr. Rockler: No.

Chief Justice Rehnquist: Certainly the Court said that in its opinion.

Mr. Rockler: No, I don't think the Court said it was an express agreement.

They said this was an operating agreement whereby the taxpayer paid in an estimate and the Government put it in the suspense account.

And we have exactly the same situation.

I refer the Court to the record in this case.

There is a certificate of assessments which shows that until such time as the return was filed and assessment was made, the withholding taxes and the estimated taxes were... were held in a suspense account as credits.

As a matter of fact, the code says that withholding taxes are only credits.

It doesn't say that they're the payment of income taxes.

Section 31 of the code says that the withheld taxes are credits to be used against the income tax.

Now, the Government has carefully avoided any discussion of the two governing regulations in this case.

Justice Scalia: Mr. Rockler, before you... before you get off Rosenman, there was... there was another feature in that case which... which no longer exists and is... is not a factor in the present case, and that is the Government there was... was trying to have its cake and eat it too.

It was asserting that for purposes of the statute of limitation, the... the filing... the filed date was determinative, but... but that no... but that interest would... would... well, let's see.

No.

It was asserting that for purposes of... of the statute of limitation, the date on which it should have been filed was determinative, but that for purposes of whether interest runs, the date of actual filing was determinative so that you would not get any interest on the prepayment until the return was actually filed.

Now, that feature of the law has since been changed by... by statutory amendment so that you will get interest from the date that the... at least from the return due date.

Mr. Rockler: No, no.

Under the present law, you get interest from the date the return is actually filed.

That's 6611.

You don't get interest from the return due date.

That just isn't so.

Justice Ginsburg: Well, that's to encourage you to file your return on time to say if you don't file it on time, then you won't get interest.

Mr. Rockler: Yes.

Justice Ginsburg: Isn't that the purpose?

Mr. Rockler: I... I think that is correct.

But taxpayers have no incentive to delay the filing of their returns.

There is no real risk of that, as we pointed out, particularly in the reply brief.

Justice Ginsburg: What was it...

Mr. Rockler: If they've overpaid, they are losing interest for whatever period of late filing they're engaged in.

If they've underpaid, they're subject to penalties and interest which continue to run during the period of delay.

So, there's no incentive on the part of taxpayers to file late.

There are only penalties attached to that.

And there's no advantage in litigation to filing late because the burden of proof and the burden of coming forward is going to be the taxpayer's in a refund suit.

Justice Ginsburg: Mr. Rockler, I'm concerned that the argument that you... you are making would be detrimental to many taxpayers, and let me give you this example.

Suppose... let's take the year 1988.

$ 100,000 in both estimated taxes and withholding were paid in, and then a return is filed in the year 1993, as here.

And the Commissioner determines that the taxpayer underpaid by $ 10,000.

Then on your theory, the taxpayer would owe interest on $ 110,000 rather than just $ 10,000 because he had never paid the tax.

Mr. Rockler: No.

I think in that case, on the hypothetical you gave, if... if there were accumulated withholding and estimated taxes, as in our case, there would not be any interest with respect to those amounts that accumulated as a suspense credit item.

If there were no payment whatever...

Justice Ginsburg: But they were not paid.

Mr. Rockler: If there were no payment whatever in any form, then you're right.

Justice Ginsburg: Well, you say it's payment for some purposes and not others?

Mr. Rockler: No, no.

It's not payment.

It's a credit.

The... the payment in the nature of a deposit, which is what Rosenman described the remittance as, does serve to mitigate against an interest charge against the taxpayer.

He doesn't get any... he doesn't get any benefits for the delay in filing, but he isn't penalized because the money is there available to the Government during that interval.

Chief Justice Rehnquist: But what... you say that quite confidently, but what statutory provision is it that says interest will run or not run in that situation?

Mr. Rockler: Section 6611.

Chief Justice Rehnquist: Which you don't cite in your brief.

Mr. Rockler: That... that is a section which neither the Government nor the taxpayer here attached to the briefs, I regret to say.

I would like to have...

Justice Scalia: Let... let me come back to... to Rosenman.

You're quite right.

The... the issue in the case was not an issue of timing, but it was an issue of whether... whether the... the prepayment was a prepayment of taxes.

If it was a prepayment of taxes, interest would be due.

If it was only a deposit, interest would not be due.

And the Government was claiming that interest was not due because it was not a prepayment of taxes for that purpose, but that it was a prepayment of taxes for the purposes of the statute of limitation.

It was taking an inconsistent position on that issue.

Now, that is not the situation here because the statute now makes it clear that even if it is not a prepayment of taxes, even if it is just... whatever it is, interest runs on it, on the overpayment amount.

Mr. Rockler: I... I think you're quite correct, Justice Scalia, in your observations with respect to what the case says.

I think Justice Frankfurter made that point very clearly.

He said you can't have payment for statute of limitations purpose, but not payment for interest purpose.

Justice Scalia: And we don't have that problem here.

Mr. Rockler: But the holding of that case is more basic than that observation.

The case really stands for the proposition... the Court made it expressly clear... that you cannot have the payment of a tax when you don't know what the tax is.

You can't apply a credit to an unknown item.

If I prepaid to a department store $ 100 because I think my wife is going to run up charges, I haven't paid any... any debt to the department store until such time as she runs up the charges.

If I'm a law firm and I receive a retainer, which is to be applied to time...

Justice Scalia: No, but the charges have been run up here.

I mean, you're liable for the tax not by reason of your filing the return.

You're liable for it by reason of your breathing in and out for a year...

[Laughter]

And... and getting some income.

Mr. Rockler: You could say exactly the same thing for the estate taxes in the Rosenman case.

You could say when the decedent died, there was a distinct tax liability immediately.

That is not...

Justice Breyer: But in Rosenman...

Mr. Rockler: the position this Court took then.

This Court said until such time as the tax is known and asserted.

And it could be asserted in two ways.

It could be asserted by the taxpayer filing a return or self-assessing himself in a sense.

It could be determined by the Government asserting an amount.

They could file a return for him.

That's an available course for the Government.

But...

Justice Breyer: Is... was there at the time of Rosenman...

Mr. Rockler: Pardon me?

Justice Breyer: At the time, did the statute specifically say... the language that we have... that an amount paid as an estimated tax shall be deemed to have been paid on such and such a date?

Mr. Rockler: No, no.

Justice Breyer: No, it didn't.

Mr. Rockler: That... that section was not applicable.

Justice Breyer: Well, so we have a new section and we have also the point Justice Scalia made.

And I wondered as well in Rosenman, although Frankfurter did use the word estimated taxes, I don't know that the payor thought of it that way because the payor said this payment is made under protest and duress, just to avoid penalties and interest, since it is contended by the executors that not all of this sum is legally or lawfully due.

And so, one might say given that they didn't think they owed it, it wasn't the payment of an estimated tax.

But here it is an effort to pay an estimated tax.

Mr. Rockler: Justice Breyer, I think the answer is that the transmittal letter of the taxpayer, according to the Court, said it was an estimate on Federal estate tax.

The Court I think is referring to the transmittal letter as protesting and also as trying to avoid penalties and interest.

Justice Kennedy: But... but as Justice Breyer's questions suggest, we're living in a post-Rosenman world, and after Rosenman, the Government made express provision in its revenue procedures so that if you paid a remittance as a deposit, you had to expressly say it was a deposit.

So, even if Rosenberg were wholly in your favor, it seems to me to have been altered by the revenue rulings after that point saying that you must make... make it very clear that this is a deposit.

And that wasn't done here.

Mr. Rockler: Justice Kennedy, if I may say so, both withholding taxes and an estimate do nothing but give rise to credits, and there are regulations in effect which say these credits are to be applied... future tense... when the return is filed, and they are set up against the income tax then known to be due.

Justice Kennedy: Well... well, then you're saying that the revenue procedure adopted in the wake of Rosenman was absolutely to no effect.

Mr. Rockler: No, I'm not saying it's to no effect to taxpayers who are aware of it.

A revenue procedure is not widely disseminated and not viewed necessarily as law.

There's a difference between a rev. proc. and a formally adopted Treasury regulation.

If the Government wants that to be the sole method by which anybody could remit a payment to be treated as a credit or a deposit, then why doesn't it adopt a regulation which says so?

We have regulations in this case, and the regulations are favorable to the taxpayer in this case.

And you will find a glaring omission of any reference to those regulations in the briefs by the Government.

I mean, those regulations provide that the tax is paid on the return.

The overpayment is determined on the return, and credits are applied on the return.

As to...

Justice Ginsburg: But, Mr. Rockler, the... the taxpayer, instead of filing this under the form for a deposit, signed a voucher that went along with his estimated tax payment that said he was tendering so much as an income tax payment.

That was the word used on the voucher, was it not?

Income tax payment?

Mr. Rockler: The... the voucher is a voucher for an estimated tax payment.

It's an estimated tax form.

Justice Ginsburg: Yes, but the words were I tender this as an income tax payment.

Mr. Rockler: The... the taxpayer as such is not the ultimate in sophistication on tax matters.

When he picks up a form which says estimated tax voucher, that's what he thinks he's paying, and he certainly is paying an estimate.

He doesn't know what the tax is at that point.

In this particular case, as the Court well knows, the taxpayer had no records and asked for them from the Government.

Ultimately he got them from the Government, but he got them 4 years later.

Until such time as he got the 1099's which showed his income receipts, until he got his prior year's return which showed his capital loss, he couldn't file a return.

He was absolutely blocked.

Now, he certainly wasn't paying a tax at that point.

Justice Ginsburg: Well, that was not... that was no fault of the Government, was it, Mr. Rockler, that he didn't retain...

Mr. Rockler: No, no.

Justice Ginsburg: his return?

Mr. Rockler: No.

I'm... I'm not asserting that by virtue of these facts he's equitably entitled irrespective of the statute.

I'm saying the statute doesn't apply.

The reason the statute doesn't apply is, to quote the essence of Rosenman, he didn't know what the tax was and neither did the Government.

Nobody knew what the tax was at that point on the deemed return date.

Justice Scalia: Mr. Rockler...

Mr. Rockler: I think what's involved here is a... is a serious misreading of 6513(b).

Justice Scalia: Mr. Rockler, you seem to be making a sort of a... I don't know... a philosophical argument that it is impossible to make a prepayment on a debt unless the precise amount of the debt is... is known, and... and that doesn't seem to me true.

Let's... let's assume I'm leaving on... I'm going to be out of the country for 2 months and... and I know that I have run up credit card charges, and that when the credit card bill comes, I won't be here to pay it, and so I'll be charged interest later.

Even though I don't know the... the precise amount of my indebtedness, I know that I am indebted to the credit company.

I could write a check and mail it off to them in advance of their submitting to me the precise bill for... for the last month, and that would be a perfectly valid prepayment of my debt.

Payment of my debt in advance of the date on which they assess me.

And it seems to me that's precisely what happens here.

There's no... there... there's no philosophical objection to it.

Mr. Rockler: No.

I think there's a difference between a credit and a bill, a... a stated bill with a specific amount.

I... my point of departure is this Court's decision in the Rosenman case.

That is what this Court said.

It said until such time as you know what the tax is, until it's been asserted, until it's been specified, you can't be paying it.

Now, in your credit case, it is true you will have on deposit with your potential creditor an amount, but you haven't paid any bill at that point because there isn't any bill, and you don't pay an income tax until you know what it is.

And that... that is exactly what Judge Harlan in the Lewyt case, which is cited by... by the Government in its brief, said about Rosenman.

This is Judge Harlan who was later Justice Harlan, Second Circuit.

And I'm quoting from 215 F. 2d 518, a Second Circuit case at 522-523.

I quote.

A remittance which does not satisfy an asserted tax liability should not be treated as the payment of the tax.

That was his conclusion from Rosenman.

That's my conclusion from Rosenman.

How can you say that every credit constitutes a payment of a future bill?

Justice Ginsburg: Mr. Rockler, what... I'm not familiar with that case.

Did it arise under the '39 code or the '54 code?

Mr. Rockler: Since the case was decided in '54, it must have been the '39 code.

Justice Ginsburg: Right.

So...

Mr. Rockler: Now...

Justice Ginsburg: but we have... we have a different code, and we have a different Government practice.

Whatever you have explained about credits, Justice Frankfurter did use the word escrow, that this was put in an escrow account.

So, it sounds like a special arrangement that the Government had made.

Mr. Rockler: No.

I don't think you can view the Rosenman case as peculiar to the '39 code.

The language of that case is broad language.

Now, the Government hasn't...

Justice Ginsburg: Yes, but the statute read may not shall in... in '39.

Mr. Rockler: The... the... that is correct, but in the '54 code, in the legislative committee reports that accompany it, there was no intent really to change anything except the deemed due date of returns.

That was extended by 1 month.

Under the '39 code, you had a 2 and a half month period for filing returns.

Under the '54 code, a 3 and a half month period.

There is nothing in the history of that statute, there's no... no discussion whatever of the changes which some draftsman inserted there and which I think got by unnoticed.

There was no intent to change anything except the due date.

So, I don't think the distinction is all that significant.

Moreover, getting... getting back to basics, the Rosenman case stands for the broader proposition, which I have asserted here and which I believe, namely you cannot pay a tax until you know what it is.

You can set up credits.

And there's no detriment to the Federal revenue or the revenue system by the position we're taking here.

It's the taxpayer who, filing late, suffers whatever penalties there are.

The Government doesn't suffer any penalties.

The Government doesn't lose track of taxpayers.

Nowadays we're in the computer age.

Argument of Kent L. Jones

Chief Justice Rehnquist: Thank you, Mr. Rockler.

Mr. Jones, we'll hear from you.

Mr. Jones: Mr. Chief Justice, and may it please the Court:

There really is a simple, straightforward, textual answer to the question presented in this case, and it only takes me about a minute to describe it.

Section 6511 of the code limits the amount of any refund to the amount of taxes paid during the 3 years prior to the filing of the refund claim.

The question in this case is simply when are remittances of estimated withholding taxes to be regarded as paid for the specific purpose of the refund limitations in section 6511, and the introductory clause of section 6513(b) expressly and concisely answers that question, for it says that remittances of estimated tax and withholding taxes shall, quote, for the purposes of section 6511, be regarded as paid on the date the return is due.

The history of this provision makes perfectly clear...

Chief Justice Rehnquist: That isn't quite the way the... the... at least the version of 6513(b)(2) that I have before me reads, where it says... would you... would you read the exact language again?

Mr. Jones: Well, the language that I was emphasizing is up there after prepaid income tax where it says, for purposes of section 6511.

Chief Justice Rehnquist: Ah, or 6512.

Mr. Jones: Right, and 6512 is the statute of limitations in Tax Court cases.

Chief Justice Rehnquist: Okay, and then... then... so, from there you dropped down to the text of...

Mr. Jones: Then I was summarizing the rest of the text.

(b)(1) says that you... that you use the... for withholding taxes, you treat those as paid on the date of the... that a return is due, and then (b)(2) says that for estimated taxes, you treat those on the date the return is due... as paid on the date the return is due.

Chief Justice Rehnquist: So, (1) and (2) distinguish between two different situations.

Mr. Jones: Both of which are involved in this case because we have in this case both withholding and estimated taxes, and so both (b)(1) and (b)(2) apply here.

And under both of those provisions, Congress said that for purposes of the refund limitations in section 6511, these kinds of payments are to be regarded as made... paid on the date the return is due.

Chief Justice Rehnquist: Now, you also said 6511...

Mr. Jones: Yes, sir.

Chief Justice Rehnquist: in your 1-minute summary.

Mr. Jones: That's right.

And that should be on the prior page.

Chief Justice Rehnquist: Now, what... what part of section 6511?

Mr. Jones: The... the particular part involved here is 6511(b)(2)(A), which begins to be quoted on appendix A-11 of the blue brief.

Chief Justice Rehnquist: Okay, and what... point to the specific language...

Mr. Jones: The specific language would be in the... if the claim was filed by the taxpayer during the 3-year period following the filing of the return, and that references us back up to 6511(a).

But if you filed within the 3-year period filing... following the return, then the amount that the... the amount of the credit or refund shall not exceed the portion of the tax paid within the period immediately preceding the filing of the claim equal to 3 years plus the period of any extension.

And so, I was summarizing this provision when I said that in... 6511(b)(2)(A) limits the amount of the refund or the taxes paid within the period of 3 years of... of the refund claim.

And then you look to 6513(b) which says for purposes of that section, withholding and estimated taxes are to be regarded as paid on the date the return is due.

The legislative history of this is perfectly clear.

We've cited it in our brief.

When Congress enacted these interrelated provisions, it did so for the very purpose of answering the question in this case, and it says that these payments are to be regarded as paid for purposes of the refund limitations on the date the returns are... are due.

Justice O'Connor: Mr. Jones, Mr. Rockler referred to regulations that he thought were supportive of his position.

Would you address the regulatory scheme?

Mr. Jones: Well, the only thing that he... he cites in the regulations are simply provisions that direct taxpayers as a general matter to make their refund claim on their return.

If they've made an overpayment... as we all know, the last line on the return is you put in the overpayment.

That satisfies the regulatory refund...

Justice Kennedy: Well, Mr. Rockler wasn't overly impressed with your revenue procedure, and he says there's a glaring omission because the regs don't pick this up.

Why don't you have a regulation?

That was his argument.

Mr. Jones: Well, this is a procedural rule, so I mean, it is a regulation in the... in the broad sense of the term.

It is a rule adopted by the Service to govern this procedural aspect of its work.

It's not a substantive regulation like a Treasury regulation that might interpret some substantive provision of the code, but it sets out procedures that the Service will follow in accepting deposits.

And... and I should emphasize that... maybe out of context, but the reason why we accept deposits is not discussed in any of these cases and it's kind of obscure.

The only reason why a taxpayer would ever want to make a deposit would be because he wanted to preserve his opportunity of going to Tax Court.

If he pays the tax, then there would be no deficiency to be noticed, and therefore no way for him to go into Tax Court to review the notice of deficiency.

Justice Breyer: How... how is it supposed to work if some taxpayer doesn't know that much about it, is in some complicated situation?

He files his return all right, but he isn't certainly about something.

So, he sends in a check for $ 10,000 and just says, gee, I... I don't have a clue what I'm supposed to do here.

Here are all the facts and sets them all out.

And he never hears from anybody for 5 years or so.

And finally, after about 5 years, he gets back a letter, oh, you don't owe anything.

And... and what's supposed to happen?

Mr. Jones: Well, if he... oh, you mean that he didn't even owe the $ 10,000.

Justice Breyer: Yes, right.

Mr. Jones: Well, that would certainly be an unfortunate situation.

[Laughter]

I'm not sure that I can think of a situation like that ever happening, but...

Justice Breyer: Well, I don't know.

[Laughter]

Mr. Jones: To try to parse through the... the hypothetical, if... if he made it as a payment, which I assume he did because he didn't...

Justice Breyer: He just... you know, he gets his tax... a very honest person.

He sends it in.

He says, I couldn't owe more than this.

I... I'm sure I don't owe more than $ 10,000.

Help.

I don't... can't... I... I never go near lawyers.

[Laughter]

I expect you to help me.

Just, please, tell me what I owe.

I'll pay it.

Mr. Jones: I can answer your question.

He made a payment.

He made a payment that was applied against his taxes.

If he didn't need to make the payment, he made an overpayment.

If he made an overpayment, he should have filed a refund request in a timely manner.

Justice Breyer: Yes, but he didn't because he never heard from anybody for 5 years.

Mr. Jones: Well, I'm not sure what it was he needed to hear from us because...

Justice Breyer: Well, in other words, suppose 5 years goes by.

He never hears a word.

He sent in the $ 10,000, and then he gets a letter 5 years later, you didn't owe anything.

Mr. Jones: All taxpayers are on notice of the law, and the law in this respect says...

Justice Breyer: He's out of luck.

Justice Stevens: That's this case, isn't it?

Mr. Jones: On the bare facts that you described, yes, he's out of luck.

Justice Stevens: Isn't the hypothetical precisely the same as this case?

Mr. Jones: I mean, that's why there are statutes of limitations that are designed to cut off stale claims.

You've described what is a stale claim.

Justice Scalia: We have a self-assessment system.

This is a taxpayer who simply doesn't want to... doesn't want to self-assess.

Mr. Jones: That's exactly right.

Justice Scalia: And I guess you're not allowed to do that.

Mr. Jones: The whole concept of... of petitioner's position is alien to our system of taxation.

He says you can't pay a tax until it's been assessed.

We have a system of self-assessment.

Taxpayers are supposed to figure out their own tax liability and are supposed to pay it with the return at the time the return is due.

Section 6151 of the...

Justice Scalia: It may be worth $ 10,000 not to have to do that.

Mr. Jones: [Laughter]

Mr. Jones: Well, he should still file a return even if he doesn't owe us money because, I mean, both as a matter of exposing himself to penalties, but beyond that, I mean, we can't know... we can't go out and investigate everybody without any record.

We need a return to... at least as a point of departure, to figure out people's liabilities.

Justice Breyer: I'm simply pointing out it... it could be a really honest mistake situation.

The taxpayer has done everything possible, and perhaps the IRS is at fault if they don't respond promptly.

Now, I guess what you're saying is there's just no remedy, and I wonder if there... there is any.

Justice Scalia: And I agree...

Mr. Jones: People need to be diligent in protecting their rights.

I... I don't think...

Justice Souter: Well, you might also say that the taxpayer has not done everything he could possible.

Mr. Jones: That's right.

Justice Souter: He's supposed to file... he's supposed to file a return.

Mr. Jones: And he's supposed to file a return, and he's supposed to file a refund claim.

And... and in your hypothetical, his failure to comply with the law...

Justice Breyer: He did in my hypothetical.

He did.

Mr. Jones: His failure to comply with the law means that he's not entitled to a refund.

The... the court of appeals disposed of this case in... in a one-page opinion, and frankly, that... that was not an unrealistic approach because the text of the statute is clear.

Congress plainly has it within their right to deem what is paid for purposes of the limitations period, and they quite clearly did so and quite clearly intended to do so.

Now, what petitioner says is, well, his only textual argument is that, well, these are payments of estimated taxes and withholding taxes and that's somehow different from income taxes.

And... and that's plainly not correct.

As... as has already been pointed out, the title of... of this provision, when Congress enacted it, is prepaid income taxes.

And section 6315 of the code specifically describes estimated tax payments as payments on account of the income tax.

And section 6401(b) specifically says that if you have withholding... withholding credits, the only way... that are applied against your income tax, the only way you can recover them is if they have resulted in an overpayment of your income tax.

And the only way you can recover them is if you file a timely claim under 6511 for recovery of an overpayment of income tax.

Congress really worked pretty hard to make all these provisions work together, and they really do when you carefully pull them apart and look at how they work.

The... setting aside the text of the statute, petitioner then says, well, just as a matter of logic, you can't pay a tax before it's actually been finally determined and assessed.

Well, we're supposed to self-assess.

We're not supposed to wait for the Service to tell us what our obligations are.

In the Manning case, this Court pointed out that on the date the return is due, under section 6151 of the code, every taxpayer has a positive obligation to pay his tax without, in the words of the Court, an actual assessment of it.

An assessment is not a prerequisite to liability.

An assessment... interest accrues on a liability without assessment.

The United States may bring a suit to enforce a tax liability without assessment.

An assessment is simply, in the words of the code, an administrative record of the liability.

It is an administrative determination which, when made, authorizes additional enforcement devices such as liens and levies, and it gives us an additional 10 years to collect the tax.

But it's not a prerequisite to liability, and... and payments are routinely to be made before the tax is assessed under the code.

Justice Ginsburg: Mr. Jones, Mr. Rockler does get some comfort from the language in Rosenman that says that you don't pay it till it's determined how much it should be.

Mr. Jones: Rosenman really addressed a completely different subject.

First of all, let me point out, as I begin discussing Rosenman, that it did not address or consider the provisions at issue here, and so it doesn't consider and certainly doesn't override the clear textual determination that these types of remittances are paid as a matter of law on the date the return is due.

What Rosenman dealt with was something entirely different, an administrative practice that Congress has repudiated and that no longer applies.

In Rosenman, before the case arose, the Service had long taken the position that a remittance of tax from a taxpayer who in fact owed no liability would not be treated as a payment of tax but would be held in a suspense account on which no interest would accrue.

The reason the Service had done this back in the '20's and '30's was because of a concern they had about a potential abuse.

The potential abuse related to the fact that overpayment interest is more than the interest on ordinary Federal funds.

Right now it's 3 percent over the short-term Federal funds rate.

The Service didn't want the Treasury to be used as a bank that would allow taxpayers to simply... in the words of the Congress that discussed this, to simply throw the money at the Service and go... and collect this higher rate of interest.

So, to prevent the abuse, the Service had a prophylactic approach of saying all of these payments from taxpayers who don't owe us anything we're going to put in a suspense account.

Now, what the Court said in Rosenman was, well, if you treat these matters as non-payment...

Justice Scalia: Excuse me.

Before you go on any further, how did they know that the taxpayer didn't owe them anything?

Mr. Jones: They had no... no way in...

Justice Scalia: I mean, until there's...

Mr. Jones: The Service had nothing in their records to indicate what the liability would be for the taxpayer.

Justice Scalia: Okay.

So, it... the taxpayer could...

Mr. Jones: Oh, yes.

The taxpayer might have owed money, but if from the Service's perspective... this broad, prophylactic approach was, if from the Service's perspective there was no indication of what that liability was, they'd just suspense it.

They didn't want to... they didn't want to be used as a bank.

Justice Souter: Well, did the suspense account apply only to estate taxes or to income tax payments?

Mr. Jones: No.

This... this was generally applied to other types.

My assumption is it was to any type of tax obligation for which overpayment interest would have been available, which would...

Justice Souter: So, it would have...

Justice Kennedy: Your argument about not using the Government as a bank... it seems to me that's his explanation for 1613(b)(2), namely that you didn't want the... the date the estimated payment was made to serve as the date to begin the running of interest.

So, that kind of fits into his interpretation of the section.

Mr. Jones: No, because as I will explain to you next, Congress repudiated the Service's practice in the... in the Current Tax Payment Act of 1943.

In section 4(d) of that act, Congress said basically stop treating these matters as deposits.

Treat it as a payment even if the taxpayer has no liability.

In the legislative report on that bill at page 28 I think... it might be 48, but I think 28... the... the Congress discusses this and says the Service has overreacted to this potential abuse.

We don't think it's that big a problem.

But there might be a problem if some taxpayer threw money on the Treasury when they really did not, in good faith, have any belief that they had a liability.

And so, Congress worded this provision very carefully.

It's section 4(d) of the... of that act.

It's now section 6401(c) of the code.

And what it says is that a payment shall not be treated not as an overpayment merely because the taxpayer had no liability.

That protected the Service's right to say in a particular case, well, I'm not going to give you overpayment interest even though it's a payment.

I'm not going to give you overpayment interest because it's not a good faith overpayment.

You were throwing money at me.

But as the United States said in its brief in the Rosenman case, on the last two pages of its brief in the Rosenman case, under that new statute the payment transmitted in Rosenman would have been treated as a payment.

It was treated as a payment on which overpayment interest would accrue.

And, indeed, the strange argument the United States made in the Rosenman case was that the legislative determination that that was to be treated as a payment for purposes of overpayment interest somehow resolved an uncertainty that had existed in the past about whether those kinds of payments would be held as suspense or as payments for purposes of the limitations provisions.

Well, the Court, to be blunt, would have none of that.

In the Rosenman case, the Court said it will not do to treat these funds as a payment or not as a payment depending on whether the Government wins or loses.

And because the Government treated... at the time of the Rosenman case arose treated it as a deposit and not as a payment, that's... that's the way it should be treated.

Now, after Rosenman, after the new section 4(d) of the Current Tax Payment Act, those types of remittances are not held in special suspense accounts, are not held in deposits.

The only way we accept a deposit now is under the revenue procedure.

And under the revenue procedure, it is generally required that the taxpayer specifically designate at the time of the remittance that he is making a deposit and not a payment, and that protects everybody and everybody knows what's happening.

Justice Souter: Given the I think the Tax Payment Act of 1943, what's your authority to accept the deposit anymore under... under your revenue procedure?

Mr. Jones: I suppose it's... it was not statutory.

It's consent.

It's contractual.

If the... if the taxpayer wants to... wants to reserve his right to get to Tax Court and make his deposit instead of making the payment, we can agree to that.

We can't compel it.

We can't, under... under the Current Tax Payment Act, we can't compel it.

Chief Justice Rehnquist: The Tax Payment Act sets more or less a default rule absent the Government's agreement to the contrary?

Mr. Jones: Well, I think the Tax Payment Act sets the rule, but I think that this is a situation that where the parties can vary it by agreement.

I don't... I don't know of a reason why we couldn't, although I have to confess it isn't perfectly clear to me why the Service is willing to participate in these types of agreements, but I think it's a historical thing.

And there may be one explanation.

Congress has provided that a payment of a tax made after the notice of deficiency has been issued and the... and the Tax Court case has begun that if you pay it after you've begun the Tax Court case, then you don't divest the court of jurisdiction.

It's only if you pay it before the case has begun that you do.

And so, these deposit agreements allow the taxpayer to... to get into Tax Court even by curtailing the interest before the notice of deficiency is issued.

Justice Souter: Mr. Jones, I just was going to... I understand your argument.

I understand also that his counter-argument isn't necessarily controlling with regard to what you say.

But it, nevertheless, is true, I think, that his reading of... of 6513(b)(2) would at least serve the function of preventing the Government being used as a bank by somebody who wanted to overpay his estimated payments.

Mr. Jones: It's consistent with that goal.

Chief Justice Rehnquist: That's really all I'm...

Mr. Jones: It certainly doesn't replace it, I mean.

The... the one other thing I wanted to say about the revenue procedure, which our brief doesn't address, and I want to make sure there's no confusion.

In paragraph 4.04 of the revenue procedure, if a taxpayer makes a remittance at a time when there's no identified liability and we don't know how to apply it... he doesn't designate the year or the tax to which the remittance would apply... we will temporarily treat it as a deposit.

We will promptly notify the taxpayer of this and request him to tell us how he wants us to designate it.

And so, in that one brief instance, there can be a deposit without an express designation.

There is a... a broad point that I want to mention, and that is if petitioner's argument were accepted, it would seriously disadvantage the vast majority of taxpayers who pay timely, who file timely returns, and who file timely claims for refund.

And that is because on petitioner's theory, payments of estimated taxes, of withholding, payments made with... with the return, and any payment made before the tax is assessed would simply be a deposit and would not be a payment on which overpayment interest would run.

Since under the code, the Service can take 3 years after the return is filed to make an assessment, petitioner's theory would mean that these taxpayers would lose their overpayment interest for that 3-year period.

Justice Ginsburg: When I put that case to Mr. Rockler, he said no, that's not what would happen.

Mr. Jones: Well, I... I didn't understand his answer, and I don't agree with it.

The overpayment interest runs... oh, I... I'm sorry.

Mr. Rockler was making the... the point that... that overpayment interest doesn't begin to run from the date of the return if you file a late return.

I didn't hear him to be making any other contention on that issue.

From the date... even if you filed... even in Mr. Rockler's situation, if you file a late return, you get... the Service could still have 3 years to assess, and his taxpayer would lose 3 years of interest even if... even from that overpayment... I mean, even from that special date that the interest begins to run.

For interest to run on an overpayment, there has to be an overpayment.

There can't be an overpayment if there's not a payment.

His theory it's a deposit, not a payment.

So, all... all the... I think in the Brockamp case, the Court noted that something like 90 million refunds are given every year.

Most of those are people who pay their taxes through withholding, through estimated taxes, or with their return.

And none of those taxpayers would get overpayment interest under this theory.

Justice Scalia: How come you're here on this side of the case?

It raises that question.

Mr. Jones: Pardon me?

Justice Scalia: I say it... it would seem to be in the interest of the Government to be on the other side of this case.

I... I...

Mr. Jones: I think it's always in our interest to...

Justice Scalia: I've never seen this happen before.

Mr. Jones: [Laughter]

Mr. Jones: It's always in our interest to try to do what Congress intended, and I don't say that in anything other than in... in full meaning.

I mean, our job is simply to accomplish what Congress indicated we should accomplish and... and we're pointing out that what his... what Mr. Rockler's position would result in would be a drastic difference from what Congress intended, both in terms of determining when the... when the statute of limitations has run and in determining when overpayment interest accrues.

If... are there questions?

Chief Justice Rehnquist: I was going to just say... before Mr. Rockler's red light went on, I was going to ask him if there was no 54(b) issue in this case, I don't think.

Mr. Jones: [Laughter]

Mr. Jones: Thank you.

I'm finished.

Chief Justice Rehnquist: Thank you, Mr. Jones.

The case is submitted.

Attribution:

The Oyez Project

Featured:

Drye v. United States - Oral Argument

Fri, 09 Jan 2009 14:50:20 +0000

Case:

Drye v. United States

Media File:

98-1101_19991108-argument.mp3

Related Transcript:

1999_98_1101_argument.xml

Transcript:

Argument of Daniel M. Traylor

Chief Justice Rehnquist: We'll hear argument next in Number 98-1101, Rohn F. Drye v. United States.

Mr. Traylor.

You're the only lawyer to come by himself we've seen in a long time.

[Laughter]

Mr. Traylor: Mr. Chief Justice, members of the Court, may it please the Court:

For our Socratic dialogue I am armed with a borrowed Gideon and the fruit.

This is... these aids go right to the jugular of this case, and the genesis of the case, which is Chapter 3 of Genesis.

What we have here is, when the serpent extended the fruit to the offeree, free will said that the offeree had a right to accept or reject the gift.

Assuming that that offeree was a tax delinquent, the Government's position is that their 6321 Federal tax lien attached at the moment that the serpent extended the fruit.

That is not...

Justice Kennedy: Well, of course, the IRS was not in Paradise.

Mr. Jones: [Laughter]

Mr. Traylor: I'm... that is where the case starts, is with the idea of free will, that people have a right to accept or reject a gift.

The Government don't believe that.

They believe that when you have the right to make that decision and grab the fruit, that their lien attached to that personal right of decision to elect.

I don't believe that that's the law of this Court, as announced by this Court.

I don't believe...

Justice Ginsburg: Mr. Traylor, the Government is not relying on the Good Book, but it is relying on title 26 of the Internal Revenue Code and there the matter of disclaimer is dealt with in the estate and gift tax context, but it isn't... the permission for a disclaimer appears expressly in the estate and gift tax.

There is no such provision for the Tax Lien Act, so the Government is saying, Congress did not choose to provide for disclaimer in that context, so there is none.

Mr. Traylor: What Congress said was that for their tax lien to attach, the taxpayer must have property or rights to the property.

When Mrs. Drye died, at the instant of her death, the Government's position is that Mr. Drye acquired a right to property, or property in her estate.

That is not the law of the State of Arkansas, and it is not the law that this Court has pronounced.

Chief Justice Rehnquist: But as I understood it, Mr. Traylor, at least the Eighth Circuit felt that way, that under Arkansas law your client acquired a property interest upon death, because he didn't remit it for a number of months afterwards.

Mr. Traylor: Well, he has 9 months within which to make that personal...

Justice O'Connor: Yes, well, who owned the real estate during the 9 months before the decision was made?

Who owned it, do you suppose?

Mr. Traylor: The law is very clear that the estate owned it.

Justice O'Connor: You don't think, in the case of real property, that the title went to the beneficiary...

Mr. Traylor: Absolutely not.

Justice O'Connor: under Arkansas law?

Mr. Traylor: Absolutely not.

Justice O'Connor: Let me ask you this.

Did Mr. Drye have a right to transfer whatever right he had to his mother's estate before he acquired it...

Mr. Traylor: He would acquire...

Chief Justice Rehnquist: under Arkansas law?

Mr. Traylor: acquire that right if, and only if, he accepted, took a bite of the apple.

Justice O'Connor: You don't think there's any way, under Arkansas law, that before all of this happened, even before his mother died, could he transfer whatever right he had to someone?

Mr. Traylor: Only if he took a bite of the apple.

Nothing vests until you accept the gift, the offer of the gift.

You... there has to be an act of an acceptance.

At that point, Mr. Drye would acquire an interest or a property in his mother's estate sufficient for the tax lien to attach.

That never happened.

Chief Justice Rehnquist: Mr. Traylor, the district judge who, I'm sure, must have been an Arkansas practicing lawyer before he was appointed to the bench, found against you on this point, and the court of appeals, which certainly knows more about Arkansas law than we do, found against you, saying that there was a property interest under Arkansas law, so you have kind of a heavy burden to persuade us otherwise.

Mr. Traylor: Well, very simply, Judge Howard in the Eighth Circuit got it backwards.

Chief Justice Rehnquist: They don't realize it, though.

Mr. Jones: [Laughter]

Mr. Traylor: They will when this Court instructs them what the fact of the matter is, and the fact of the matter is that the Fifth... the Fifth Circuit and the Ninth Circuit on... I'm on all fours in near identical facts... found just the opposite, on very recent opinions.

Justice Souter: But they didn't do it on the grounds that you had no property interest.

They did it on the grounds that the disclaimer relates back, isn't that right?

Mr. Traylor: I don't think, Your Honor.

I think that they found that the taxpayer in both States never acquired an interest sufficient for a tax lien to attach.

This is not really about the disclaimer and the relation back.

It's whether anything ever vested, a right in property, or property itself, that under Federal law is sufficient.

Justice Souter: Let me ask you this.

If the administrator had announced that he was going to liquidate the estate and take the money and go to Las Vegas and have a good time, would you have had the right to do anything about that, your client have the right to do anything about it?

Mr. Traylor: Well, see, my client was the administrator...

Justice Souter: Would he have sat back and said, too bad, I have no property interest, or rights to property, so I guess the administrator can look forward to a good time?

Mr. Traylor: Had he disclaimed prior to that...

Justice Souter: That's not my question.

He hadn't taken any action one way or the other.

The administrator is on the way to Las Vegas.

Can he do anything about it?

Mr. Traylor: Yes.

Justice Souter: What?

Mr. Traylor: He can accept... he can take a bite of the apple and go to State court and say, enjoin that administrator from going to Las Vegas.

Justice Souter: And he would say, when he got to court, would he not, I have a right to inherit that property if I want to, and therefore he can't go to Las Vegas with it?

Mr. Traylor: He's bitten the apple, and he's... the tax lien has attached.

Justice Souter: Let's assume you are representing him, and he says, I'm not biting the apple, I am simply asserting a right to bite the apple, haven't bitten yet.

Justice Breyer: Can he stop?

Mr. Traylor: I believe that by... that that would be an act of acceptance by going to court and saying that I am protecting my interest.

Justice Souter: And he had a right to do that, I take it?

Mr. Traylor: I am acknowledging...

Justice Souter: And he has a right to go into court and do that, doesn't he?

Mr. Traylor: He has a right to do that when he does it.

Justice Souter: But not before?

Mr. Traylor: That is exactly right.

Justice Souter: He creates it himself?

Mr. Traylor: It's inchoate.

It's unvested.

Justice Souter: He creates the right himself?

Mr. Traylor: By an act of faith...

Justice Souter: The law of the State has nothing to do with it?

Mr. Traylor: an act of free will.

Justice Stevens: Yes, but may I suggest the difference in your hypothetical.

It seems to me that if the offeree said to the offeror, I'm not sure what I want to do.

I'll let you know in 30 days.

During that 30 days, the offeror could have taken the apple back.

But in Arkansas the court would not have allowed the offeror to take it back for 30 days, because he has a 9-month period in which to make a decision.

Mr. Traylor: This Court... well, Congress has said that you have a reasonable period of time within... to make that election.

The State of Arkansas has said that you have a reasonable period of time to make that election.

Justice Ginsburg: Where did Congress say that?

Mr. Traylor: In their identical qualified disclaimer for gift and generation...

Justice Ginsburg: Where they say, for purposes of this subchapter, being the estate and gift tax, so it's clear that they didn't say it with respect to tax liens.

Mr. Traylor: It's in the same book.

I would say...

[Laughter]

Justice Ginsburg: It's not in the same subchapter.

Mr. Traylor: A different subchapter.

I'm not a tax expert, but I can tell you for sure that the model probate code of which Arkansas, Texas, Arizona, North Dakota, and by my count 30 other States have said that you have 9 months as a reasonable... and it tracks the Federal system.

Justice Scalia: Mr. Traylor, what about stock options?

Are they taxable as property?

I mean, I have an option to buy stock in a company that I've worked for for a number of years.

I don't have to exercise the option.

I can just let it lapse.

Mr. Traylor: If you are a tax delinquent, a 6321 Federal tax lien has attached to your rights in those stock options, and...

Justice Scalia: I thought so.

Now, how does that... but how does that square with your case?

I have free will.

Mr. Traylor: Well, because you...

Justice Scalia: I don't have to bite the apple.

Mr. Traylor: No.

You have...

Justice Scalia: I can let the stock option just lapse.

Mr. Traylor: You have a vested interest.

Justice Scalia: Oh, I don't have a vested interest.

I have an ability...

Mr. Traylor: Because...

Justice Scalia: to assert an interest by agreeing to exercise the option, but I don't have to agree to exercise it.

Mr. Traylor: Assuming the options are not underwater, then that stock option is property or rights to property for 6321 because it's transferable and has pecuniary value.

Justice Scalia: Transferable?

Mr. Traylor: You could transfer the option to another.

Justice Scalia: No.

This is a nonassignable option.

Mr. Traylor: The Government says transferability, and I really don't care about... but it has pecuniary value.

Justice Scalia: It has pecuniary value only... so does your client's, only if exercised.

I have a nontransferable option to buy this stock.

The employee can only exercise it personally.

He can't assign it to anybody else.

Mr. Traylor: I believe the Government could come and seize that option and step in...

Justice Kennedy: I'm sure it can.

Mr. Traylor: And step into your shoes.

Justice Scalia: And I don't understand why it can't come and seize your client's interest in the estate.

Mr. Traylor: Because nothing had ever vested.

It was a personal right of decision that was without pecuniary value.

It was nontransferable.

It's not recognized at law or in equity in Arkansas.

Justice Scalia: How does that differ from the stock... does my stock option have any pecuniary value, if I cannot assign it to anybody?

I couldn't sell it to anyone.

I can't get a bank loan on it.

Mr. Traylor: The Government can step into your shoes and exercise...

Justice Scalia: Of course.

Mr. Traylor: Can the Government step in...

Justice O'Connor: Why?

Justice Scalia: Because it's property.

Because it's property.

So why can't the Government step into your client's shoes...

Mr. Traylor: Because...

Justice Scalia: and exercise it because it's property?

Mr. Traylor: Because the right of election is not property.

It has no value.

My client can't take a nickel for his right of decision.

By definition, a disclaimer has to be without consideration, otherwise the Government would have sued us under the Federal Debt Collection Procedures Act of 1990, the fraudulent transfer.

In fact, that is what Judge Howard has called me, and Judge Brantley, the chancellor and probate judge who adjudicated the disposition of this interesting question, called us both a... fraudulent transferors.

This thing is... Mr. Drye's disclaimer, his personal right of election, it's one of two things.

It was either a lawful act or a fraudulent transfer.

It's either a transfer, or it's not.

I suggest it...

Justice Ginsburg: I don't understand this very basic thing.

It seems to me that if I have a right to receive the entire estate, a right to receive it if I want it, then I have something of large value, and it's up to me whether I want to realize on it.

But to say that it's valueless until he takes a bite of it, I mean, he's... he can realize on it if he wants to.

He's solely in control.

Mr. Traylor: Your Honor, it's been the common law of England and this country, codified by statute in Arkansas, until you take that bite of the apple, you do not have a vested interest in her estate.

Justice Ginsburg: That's, you say is the Arkansas law.

There are States, are there not, where a person in the position of Mr. Drye would be deemed to have had the property and then given it up.

Mr. Traylor: Absolutely.

Justice Ginsburg: And then... so if we took your view of it, it would depend which State you come from whether the tax lien would attach.

Mr. Traylor: That is correct, and one of the beauties of our Federal system that different States define their interest a little bit different.

Chief Justice Rehnquist: Suppose...

Has the supreme court of Arkansas ever held that the sort of expectancy that your client had before he disclaimed was transferable, or saleable, or that it was not transferable or saleable?

Mr. Traylor: Has never interpreted our probate code since the model act was adopted in '84.

To answer your question, sure.

I mean, if Mr....

Chief Justice Rehnquist: No, I'm asking you a specific question about the holdings of the supreme court of Arkansas.

Has the supreme court of Arkansas ever held that the sort of interest your client had before he disclaimed was or was not transferable or saleable?

Mr. Traylor: The court would say that it is a transferable interest, and once you have transferred it, you've bitten the apple, your right to...

Chief Justice Rehnquist: No, I mean before you disclaimed.

During the period before you disclaimed, has the supreme court of Arkansas ever said whether or not that interest was transferable or saleable?

Mr. Traylor: I'm doing my best, Your Honor.

It's... that is an act of the bite of the apple, and...

Chief Justice Rehnquist: I'm not... don't tell me about the bite of the apple any more.

Just tell me what the supreme court of Arkansas has done, or if it hasn't done anything... I mean, this seems the key to your whole case, and if there's a case out there that is... shows the Eighth Circuit and the district court were wrong, you should surely have it.

What is that case?

Mr. Traylor: The Fifth and Ninth Circuit decisions.

Justice Kennedy: What about the Rutherford case of the State of Arkansas, which as I understand it says that one can agree to convey an expectancy in an estate?

Mr. Traylor: You can.

Justice Kennedy: All right, so why doesn't that indicate that a transfer of an expectancy is transferable, it's property, it has value?

That's what I get from the Rutherford case, and it seems to me that's the case we ought to talk about.

Now, maybe you have ways to distinguish it.

Mr. Traylor: Because it begs the question.

The interest has already vested.

The act of assignment of the...

Justice Kennedy: An expectancy is not vested.

Mr. Traylor: It is once you assign it.

You can no longer disclaim.

It would be a bar to disclaimer.

Justice Scalia: Well, I guess after you accept the devise, and while the estate is still in administration, what you have might be called an expectancy.

I'm not sure I'm that interested in what the supreme court of Arkansas has to say.

To come back to my stock option example, suppose the State of Delaware, in order to make itself even more attractive to corporations, passes a law that says, henceforward stock options in the stock of Delaware corporations are not property...

Mr. Traylor: This Court...

Justice Scalia: would the Federal Government still be able to tax those stock options?

Mr. Traylor: This Court answered that question very clearly in the National Bank of Commerce case, which I believe to be the leading case on the question, and States can't define what is or is not property.

Justice Scalia: For purposes of the Federal tax law.

Mr. Traylor: Yes.

Chief Justice Rehnquist: So...

You say States can't define what is or is not property for purposes of Federal tax law?

Mr. Traylor: They cannot.

Chief Justice Rehnquist: I thought our cases held just the opposite, that the statute says if you have property the Government can get it, but whether or not you have property is up to State law.

Mr. Traylor: You look at the interest under State law, and then under National Bank of Commerce you then look to see if that interest is property or rights to property, and the definition primarily is, does it have pecuniary value.

Justice Scalia: The State law defines your rights, but whether that bundle of rights, whatever it is, rises to the level of being property under the Internal Revenue Code is a matter of Federal law.

Mr. Traylor: Precisely, because of your Delaware example.

You can't let States define what has incumbered the tax man.

Justice Stevens: Then it's irrelevant for our purposes that as a matter of Arkansas law the decision to disclaim relates back to the date of death, and that therefore the... as a matter of Arkansas law he never had any property.

That's irrelevant, is that right?

Mr. Traylor: My best answer is, you look in depth at State law to ascertain what is the nature of the interest or right under State law, and if you'll do that in this example, you will find that Mr. Drye never acquired an interest sufficient to be defined under Federal law as property, or rights to property.

Justice Ginsburg: Mr. Traylor, I'm just curious about why the taxpayer, Mr. Drye being in this situation, he didn't have his mother write a will leaving the estate to the daughter.

Mr. Traylor: We had an appointment with her on the day of her death to execute a will.

That really affected... I mean, that's why my name is in the caption.

I mean, that was what was to happen, and it's just one of those things in life that, in fact, Mr. Drye did not want to go talk to his mamma and tell her... Mr. Drye was 70, his mamma was almost 92, I believe, at the time.

He didn't want to go tell his mother, sign this piece of paper so that we don't have to be up here today.

Justice Scalia: If he had done that, what if you... if it's not an intestate disposition, but there is a will, and you are one of the beneficiaries of the will, all right, and what if you say, I don't want this property.

You simply decline the bequest.

Mr. Traylor: That has been the common law of England and this country for...

Justice Scalia: You can do it?

Mr. Traylor: hundreds of years.

Justice Scalia: You can do it?

Mr. Traylor: Absolutely.

Justice Scalia: And are you... is that considered... your interest in that bequest considered property for purposes of the Federal tax law?

Mr. Traylor: The Fifth and Ninth Circuit said it wasn't.

The only circuit that has said it is is the Eighth Circuit.

Justice Scalia: No, I'm talking... yes.

I'm not talking about intestate disposition.

I'm talking about a bequest, and...

Mr. Traylor: The Fifth and Ninth Circuit were both... were both bequests.

Justice Scalia: Do you think the two should be the same?

Mr. Traylor: Absolutely, and that was the purpose that the commissioners on uniform State laws got together and said, look, there isn't any reason... for the last 500 years we have let people have the freedom to decline gifts in... bequests, not make a person an owner against their consent, but if it's an inheritance you will take, whether you will or not.

That was the law in England and the United States for a long time.

The commissioner got together and said, look, there isn't any reason for that, particularly as you look at the Federal tax consequences.

One is a transfer, one is not.

They got together back in the mid-sixties, they removed the common law anomaly of... feudalism is where that distinction arose hundreds and hundreds of years ago, and the State of Arkansas has adopted it, Texas, Arizona, North Dakota, and by my count 30 other jurisdictions.

They have removed the distinction between the two of them.

This case is... the Fifth Circuit decision is right on point, and it's the best analysis that I have seen of it, and the recent Ninth Circuit decision.

Both of them to me are very thoughtful decisions, and I understand that this is not a very palatable result that has resulted.

Mr. Drye didn't pay his taxes.

The Government needs the taxes, and through this sleight of hand... but these people across the street over...

Justice Scalia: The Government doesn't really need the tax.

They had a surplus, I think.

Mr. Jones: [Laughter]

Mr. Traylor: Well, the people across the street in Congress can very easily change it.

In their wisdom, they have chosen not to make a disclaimer a fraudulent conveyance.

In fact, in the State of Arkansas Mr. Drye would not have had this ability to have disclaimed up until about the mid-eighties, because at that time the law was an insolvent beneficiary could not disclaim.

That bar was removed, oh, in the mid eighties.

Chief Justice, if I might, if there's no other present questions, could I reserve the balance of my time?

Chief Justice Rehnquist: Yes, you may.

Mr. Traylor: Thank you.

Argument of Kent L. Jones

Chief Justice Rehnquist: Mr. Jones, we'll hear from you.

Mr. Jones: Mr. Chief Justice, and may it please the Court:

I want...

Justice Scalia: Mr. Jones, you don't have a stick that you're going to turn into a snake or anything like that, do you?

Mr. Jones: [Laughter]

Mr. Jones: I knew this day was going to come.

I just was hoping it wouldn't be today.

[Laughter]

I wanted to say 5 seconds' worth about the apple, and then talk about the law.

This case does not involve an offer of a gift.

This case... an offeree doesn't have any legal rights in the proposed gift.

He can't enforce the offer.

This case involves an intestate succession to which petitioner is the sole heir, had lawfully and legally enforceable rights in Arkansas.

With that background, I'd like to now talk about what the legal issue is.

The legal issue is, what's the scope of the Federal tax lien?

Section 6321 of the Internal Revenue Code creates a Federal lien in all property and rights to property of any delinquent taxpayer, and in a long series of cases, beginning with the Glass City Bank case in 1945, the Court has plainly set out the way that we're supposed to answer these questions.

First, you look to State law to see what the nature of the interest that the taxpayer has is, and then secondly, Federal law governs the determination of whether that interest is property or rights to property under the Federal lien.

Justice Scalia: Would you treat testate and intestate the same?

Mr. Jones: Almost certainly the answer would be the same, and certainly the method of answering the question is the same.

The method is, did the taxpayer have a valuable, legally protected right to receive the property.

Justice Scalia: If you treat testate the same, then what about the Government's attaching a tax lien to a gift that I've offered?

I haven't died yet, but I've offered my son a particular gift.

Mr. Jones: Your son would have no legally protected right, no enforceable right to make you transfer that property to him.

That's why I wanted to make that point at the beginning.

This case does not involve that situation.

Justice Scalia: What if State law is that, like an offer, the offer of a gift remains open until it's accepted?

Mr. Jones: I'm not sure what that would mean, but if I understand it correctly, you're saying that...

Justice Scalia: It means, all he has to say is, I accept, and the property...

Mr. Jones: Oh, he has a legally enforceable right under State law to accept.

Justice Scalia: To accept the gift?

Mr. Jones: That is a valuable interest, a valuable, legally protected right that this Court has explained in many cases.

It falls within the Federal concept of what's property for purposes of the tax lien.

Chief Justice Rehnquist: Supposing that you have some State court cases on the subject that don't speak directly to the issue in question.

What is the test?

What do you look for in State law to see whether the person has a legally protected interest?

Mr. Jones: Well, one clear example is the situation we have here, where it's the sort of interest that can be transferred, that the State will allow you to transfer the interest.

Chief Justice Rehnquist: Transferability is sufficient, then?

Mr. Jones: That would certainly be sufficient to indicate that it was a legally protected right.

Justice Stevens: But you don't think it's necessary?

Mr. Jones: No, sir, not at all.

I think there are lots of legally protected rights that involve property interests that you can't transfer, like a spendthrift trust.

Indeed, that's where this money ended up in this case.

Justice Breyer: It's true that this is a little unusual in that here you have the Arkansas statute, which says for all purposes, once it's disclaimed, it disappears.

It's not like a stock option in that sense, which I guess for a lot of purposes of State law, even after the expiration date, State law might have had some bite.

I mean, there are all kinds of State laws.

So I looked up the bankruptcy law to see how Federal law treats it.

It seems to me that under the bankruptcy provisions this would not count as an interest in property for purposes of a fraudulent transfer.

I can check it again, but I don't know if you've looked into that.

Mr. Jones: I'm not prepared to address that question.

Justice Breyer: Well, if it turns out that for bankruptcy purposes this isn't treated as an interest, I mean, I... why... you haven't thought about it, so I... you're not...

Mr. Jones: Well, I... even without thinking about it in much depth at all, I mean, what we're dealing with is not only section 6321 of the Internal Revenue Code, but a fairly large body of precedent of this Court under that statute, and...

Justice Breyer: Well...

On the precedent, I couldn't find any.

That is to say, the reason is, statutorily this doesn't count as a property right for tax purposes, because they have all these statutes, you know, that let you disclaim.

Then I couldn't find something other than that.

Now, tell me, what is... what do you...

Mr. Jones: I'm not even sure what you're referring to, these statutes that let you dis...

Justice Breyer: You have a gift tax, you have an estate tax...

Mr. Jones: Only for those purposes.

The Internal... what... and, of course, that's an entirely different subject.

Justice Breyer: Yes.

Mr. Jones: The reason that the disclaimers are allowed if they're made within this window under... for purposes of the gift and estate tax, is to avoid imposing a double tax on what's essentially a single flow-through.

But the reason that the Federal tax lien reaches this property is because the taxpayer had that legally enforceable right to decide what he wanted to do with it, which was a valuable right, and the fairness interest that I think Congress is concerned about under the Tax Lien Act is the fairness of requiring taxpayers B, C, D, and E, to pay more than their fair share to make up for the fact that taxpayer A hasn't paid his taxes.

Justice Breyer: You were going to tell me some Federal precedent.

Mr. Jones: Yes.

Well, to me the case that really tells us how to decide this question is the National Bank of Commerce case, where the Court said that in view of the comprehensive nature of the statutory language that Congress employed, that this lien reaches every valuable right, every species of right or interest that a taxpayer might invest in...

Justice Breyer: Every specie of right or interest, so in fact you would say this reaches even a similar situation under a will where the testator isn't dead yet?

Mr. Jones: Well, I... the testator can revoke his will.

We're talking...

Justice Breyer: Exactly, so...

Mr. Jones: But what we're talking about is something that is a right that the taxpayer has, and under Arkansas law, for example, the taxpayer could assign his expectancy in such an estate, and so I suppose we could take the position, which we don't need to reach in this case.

Chief Justice Rehnquist: Well, but the devisee has no action against the testator to...

Mr. Jones: Of course not.

Chief Justice Rehnquist: if the testator revokes.

Mr. Jones: Right, so I mean, it would be very hard to figure out what would be the value that the lien would attach to.

But what I want to... the point I keep heading toward is that in National Bank of Commerce what the Court said was that nothing more than common sense is required to conclude that a right to receive property is itself a interest in property that the lien attaches to, and that is precisely the nature of the interest that the taxpayer in this case has.

Justice Kennedy: What is the legal error of the Fifth Circuit right?

Mr. Jones: The Fifth Circuit in Leggett was wrong exactly for the reasons I've just described.

In Leggett, the Court said that the Federal lien doesn't attach to this right to receive property because under State law that is just a personal privilege, and it's not a property interest for purposes of State law.

And that's flatly inconsistent with the two fundamental holdings of the Court in National Bank of Commerce, the first of which is that Federal law, not State law, governs in deciding what's property under the tax lien and, secondly, that the right to receive property is property under the tax lien.

Justice Kennedy: So you look to State law to find the nature of the interest, and you look to the Federal law to see if it's property?

Mr. Jones: That's exactly what the Court held in National Bank of Commerce.

Chief Justice Rehnquist: Well, that's a little bit more intricate, more intricate than one needs, perhaps.

Mr. Jones: Well, these intricacies rarely arise, but when they arise, that's how they're to be resolved.

Chief Justice Rehnquist: What was the interest under Texas law?

Was it Texas the Fifth Circuit was deciding?

Mr. Jones: Yes.

It was... I... it was interest under a will, but the principles of property that govern the disposition of that interest are the same, whether it's intestate or testate and, indeed, as we pointed out in our brief, the State court... I mean, I'm sorry, the Fifth Circuit in Leggett seems to us to have erred in its description of how State law operates, to say all they had was a right of decision.

They had a lot more than a right to decision.

As the Eighth Circuit pointed out in this case, under the similar provisions of Arkansas...

Justice Kennedy: Excuse me, a right of rescission or decision?

Mr. Jones: Decision is what the Fifth Circuit called it.

Under the State law they have an absolute right to receive the property without doing anything.

They don't have to make a decision, any more than I have to make a decision to withdraw money out of my bank account.

It's still my property.

If I withdraw it...

Justice Scalia: He has a property right, but does he have a property right in the assets of the estate?

Let's...

Mr. Jones: Yes.

Justice Scalia: Well, I...

Mr. Jones: There's a right to receive it.

Justice Scalia: Suppose I make you a contractual offer that is open for 90 days, and under most States' laws nowadays, if I say it's open for 90 days, you can count on that.

That is worth something.

It's a beneficial contract to you.

Mr. Jones: If it's an irrevocable offer for 90 days.

Justice Scalia: It's an irrevocable offer for 90 days.

Mr. Jones: Then you have a right to accept it.

It's a valuable right.

Justice Scalia: You have a right to accept it.

Mr. Jones: It's subject to Federal lien.

Justice Scalia: Right, now what would you slam your lien on, my... the property that I have... that's the subject of the contract?

Mr. Jones: What I would... the lien would be... I would have the... I would... it depends at what stage we're at.

If I... if I try to...

Justice Scalia: The 90 days have gone by.

Mr. Jones: If I try to...

Justice Scalia: The 90 days have now gone by, the guy never exercised the...

Mr. Jones: Oh, the offer wasn't accepted?

Justice Scalia: It wasn't accepted.

Mr. Jones: Has it expired?

Justice Scalia: It's expired.

Mr. Jones: Well then, there's nothing left for us to attach to.

Justice Scalia: Well, he had a power to accept it.

He just didn't.

Just as in this case he had a power to accept it, but he didn't.

Mr. Jones: No, he doesn't have a power to accept it.

He has the right to accept it.

It's not a power, it's a right.

He can...

Justice Scalia: Okay, I'll call it a right in the other case, too, then.

Mr. Jones: He can transfer...

Justice Scalia: They're both the same.

Mr. Jones: This really is a fundamentally different concept.

He can transfer this right away.

He can, quote, disclaim it, which the Court said in the... in the Irvine case was an indirect transfer of it.

He can get rid of it.

But as this Court's held in Best, and Phelps...

Justice Scalia: What do you mean, transfer it?

Can he give it to somebody else to accept it?

Mr. Jones: Who?

We're talking about this taxpayer?

Justice Kennedy: Yes.

Mr. Jones: Yes.

He could transfer his right to receive the property by an assignment under State law.

Indeed, you don't have to look further than the State's disclaimer provisions to see that an assignment... that this interest can be assigned, because once you've assigned it, you can then no longer disclaim it.

Justice Scalia: Well, I suppose the same in the contract case.

I could say, you know, if I accept this contract, I assign to you my rights under it.

Mr. Jones: And the Federal...

Justice Scalia: You can't accept it for me, but if I do accept it, you'll have my rights under it.

I see no difference in the two cases, and I don't... in other words, I acknowledge that it's property, but is the property the assets of the estate, or is it, rather, this right to accept it, which is intangible, and which I don't know how you can...

Mr. Jones: The easiest way to answer it is by reference to the Court's decision in the Phelps case.

The Federal lien attaches to the property and to... however it is transferred, and to anything substituted for it, and because of that, the lien exists at all phases of this... I'm sorry, at all phases of this...

Justice Scalia: Well...

Mr. Jones: factual pattern.

Justice Scalia: But it seems to me that's too fast to say the lien attaches to the property.

I agree, but what is the property?

It is not the assets of the estate.

It is his right to obtain those assets.

Mr. Jones: It's his right to receive them initially.

Justice Scalia: Okay.

Mr. Jones: And then when he transfers that right the lien follows that along to whoever obtained that right.

In this case, it was his daughter, and then it attached to the assets themselves when she received them, and then it continued to attach to the assets as they were transferred to the trust, and because it continued to exist in these properties, the properties were lawfully seized for collection of taxes.

That's the fact pattern.

There was one other opinion of the court of appeals that I do need to discuss, the Mapes decision in the Ninth Circuit, which reached a similarly incorrect as Leggett, but did it by a different route.

What the Court held in the Mapes case was that the Federal lien doesn't attach to the taxpayer's right to receive the estate, because once the taxpayer renounces the interest, it's said to be renounced for all purposes under State law, and the Court said, therefore the taxpayer should be treated as if he never owned an interest in the property.

The clear error in that decision is, the court didn't cite any of this Court's decisions and, in particular, didn't cite the Mitchell case, where this Court held that a retroactive renunciation of a property interest... and I'm quoting... should not be misinterpreted as an indication that the taxpayer never owned an interest in the property.

This Court has consistently held that you look to the realizable economic value of the taxpayer's rights, and you don't look to the State law fictions of retroactive renunciations and disclaimers.

As the Court held in the Irvine case, Federal tax law is not struck blind by the State's legal fiction of a retroactive disclaimer.

The lien attached to the rights at the time that it arose, and subsequent dispositions of that, of the interest could not destroy the Federal lien.

Unless the Court has further questions...

Justice Breyer: I do, actually.

I might... I have one, and you're probably not going to have an answer, because we haven't looked it up, and I haven't, either, but as I was looking at the bankruptcy law, the reason that I was concerned is the following.

Imagine the taxpayer in this case had done just what he did, but he did it 30 days before going bankrupt.

What... if I'm right about the bankruptcy law, the interpretation would mean, if we got yours, is that his creditors, who were private, couldn't get at the money, and the reason is, it would not be a, quote, interest in property, but the Government, as taxpayer, would be able to get at the money, and the reason would be because it is, quote, a right to property.

Mr. Jones: Well...

Justice Breyer: Now, that seemed, you know, a little odd.

Mr. Jones: That is possible.

I'm not in a position to say yea or nay, but I can say it's a very common situation that the Federal tax lien applies in a situation where private creditors have no opportunity to... I mean, that's what the Best case was precisely about.

And the courts held that it doesn't matter whether under other law, State law in that case, whether you have a... whether other creditors could seize it.

This is a question of Federal law under section 6321, and under the Federal law, if the Federal law provides a lien, that's the answer to the question.

Justice Scalia: And...

Mr. Jones, can I pursue... you said that the lien attaches to his right to get the property.

If he exercises that right, it attaches to the property which is the product.

But if he doesn't exercise the option, and somebody else gets the property, that... I don't see it as being the product of his option any more.

Justice Kennedy: How can you...

Mr. Jones: I don't... what do you mean by doesn't exercise the option that... this taxpayer doesn't have to do anything to get the property.

It's his automatically.

That's the point I was trying to make earlier.

He can transfer his right, but if he doesn't do anything, if he doesn't write a disclaimer, he doesn't make an assignment, that property comes to him.

Why?

Because he already has a vested right to receive that property under State law.

Justice O'Connor: Well, indeed, this was real property, I take it...

Mr. Jones: Some of it.

Justice O'Connor: and I thought the title went to Mr. Drye immediately, subject to this State law right to disclaim later, but I thought he held the title immediately.

Is that right, or wrong?

Mr. Jones: That's the way the court of appeals described it, and that's my understanding of Arkansas law as well.

The court of appeals, I...

Justice Stevens: But again, that's not necessary to your position, as I understand your position.

Mr. Jones: No.

No.

Justice Stevens: It would be different, though, would it not, if State law provided that a beneficiary, an intestate... an heir has to file a piece of paper in court identifying himself or herself and saying affirmatively, I want the money?

Mr. Jones: It would only be different if the right were not...

Justice Stevens: He would have no right to the money unless he filed that piece of paper?

Mr. Jones: Well, if they had the right to the money, if they had a legally protected right to...

Justice Stevens: But he had to take an affirmative step to do it?

Mr. Jones: That goes back to the colloquy I had with Justice Scalia.

If he has a legally protected right that is vested in him to receive this money...

Justice Stevens: As a matter of State law, though, the nature of the interest... the nature of the interest is, he has nothing, unless he files that piece of paper.

Mr. Jones: Well, you... that's an interesting point.

I really haven't thought about that.

Justice Kennedy: It's different.

Mr. Jones: If he had to take a specific act, and he doesn't take the act, that would be a harder problem, and I'm not sure how we come out.

This case is not like that.

Justice Kennedy: You say the...

Mr. Jones: I want to point out, the Eighth Circuit said that he doesn't have to do anything.

Justice Stevens: No, I understand.

Mr. Jones: They made that point.

Justice Stevens: I understand that.

But the Commerce case was a bank account.

I mean, he clearly owned the money.

It's just a question of how much, between the joint account, isn't that right, because he had... you relied there on the fact he had a right to withdraw the money.

Mr. Jones: He had a right to receive the money, which is... I'm using the words of the Court in the National Bank of Commerce case, and they pointed out that it didn't matter whether that was a right that the State law would call a property right.

It didn't matter that he couldn't get the money until some day in the future.

What mattered was that at the time the lien attached, he had a vested right to get that money at some point.

Rebuttal of Daniel M. Traylor

Chief Justice Rehnquist: Thank you, Mr. Jones.

Mr. Traylor, you have 5 minutes remaining.

Mr. Traylor: Thank you, Your Honor.

The Government has taken all of my cases.

They're... Mitchell, down in Louisiana, those delinquent taxpayers, they had a present right, and then they tried to disclaim it, and the Court said, look, an act of God cannot remove a Federal tax lien once it's attached, and I agree with that.

The question... the problem here is, it never attached.

Irvine, the Court recently has stated that the... this idea of acceptance or rejection of estates can be based on a gift theory.

That is what we're talking... we're not talking about a mechanism to defeat creditors.

We're talking about transfer and succession of estates.

Best, that's my case.

The delinquent taxpayer at any time could go get the cash value of his life insurance policies.

The fact that he later executed a disclaimer, you can't... a State disclaimer can't extinguish a Federal tax lien once it attached.

The only people who can do that are the people across the street.

Two interesting things, the Government says that, in his opening statement that... I... that this idea of the bite of the apple, look at page 22 of their brief.

It says in the second full paragraph, an offer which can be accepted or rejected is itself an interest in property.

Here's an offer you can accept or reject.

The Government lien has attached.

I submit to you that that ain't the law of the country.

Justice Scalia: Well, it's... the Government's changed his position a little bit.

I... and says that if the offer is framed in such a way that the property is yours unless you affirmatively reject, you have property on which the lien...

Mr. Traylor: The act of doing nothing is an affirmative act that cooks your goose.

Justice Scalia: The act of doing nothing is an affirmative act?

Mr. Traylor: Exactly.

Justice Scalia: Let me contemplate that for a minute.

Mr. Jones: [Laughter]

Mr. Traylor: Over the passage of time, and I would like to...

Justice Breyer: The statute doesn't say interest, it says right.

It says you have a right to property, and if you do nothing, and you get the property, and legally you're entitled to it, how don't you have a right to property?

It didn't say interest.

Mr. Traylor: You have a right to accept or reject, but more importantly, I would like to go to your bankruptcy question.

Justice Breyer: Well, I just distinguished it away, because I said it uses interest and not right.

Mr. Traylor: On the...

Justice Kennedy: You go ahead and defend it.

Mr. Traylor: On the bankruptcy question, whether a trustee has a right to avoid a disclaimer made within, oh, I guess it would be 4 months, the Government ought to read note 17 of its own brief, where they represent that the trustee does have such a right.

I submit to you that they do not read that section of the Bankruptcy Code properly.

The only thing that generally the bankruptcy trustee can avoid are transfers.

Disclaimers, by definition, cannot be a transfer, because you cannot accept any consideration for it.

Justice Ginsburg: Mr. Traylor, do I take it from what you've just said, cannot be a transfer, that the estate gift tax provision for disclaimer, that was unnecessary, that the provision for it, for purposes of that subchapter, Congress didn't need to do that?

Mr. Traylor: Congress had to do it, because it treated people differently.

If you received under a will, you were not taxed.

If you received it by an inheritance, you will take it whether you will or not.

You can transfer it the next day, but you're going to be taxed.

And people raised Cain and said, what's the difference?

Congress said there is no difference, so we're going to treat both of you the same.

And then the State law commissioners got on the same bandwagon and...

Chief Justice Rehnquist: Thank you, Mr. Traylor.

Mr. Traylor: Thank you, Your Honor.

Chief Justice Rehnquist: The case is submitted.

Attribution:

The Oyez Project

Featured:

United States v. United States Shoe Corp. - Oral Argument

Fri, 09 Jan 2009 14:50:05 +0000

Case:

United States v. United States Shoe Corp.

Media File:

97-372_19980304-argument.mp3

Related Transcript:

1997_97_372_argument.xml

Transcript:

ORAL ARGUMENT OF LAWRENCE G. WALLACE ON BEHALF OF THE PETITIONER

Chief Justice Rehnquist: We'll hear argument next in Number 97-372, United States v. United States Shoe Corporation.

Mr. Wallace, you may proceed whenever you're ready.

Mr. Wallace: Thank you, Mr. Chief Justice, and may it please the Court:

In this test case for thousands of cases being held in abeyance, a five-judge panel of the Federal Circuit held, with Judge Mayer dissenting, that, as applied to exports, the harbor maintenance tax enacted by Congress in 1986 is an invalid tax in violation of the Constitution's export clause rather than, as we contend, a permissible user fee.

The provision at issue was enacted as part of the Water Resources Development Act of 1986, the first legislation in more than a decade to authorize development of new facilities in the Nation's harbors.

There was concern during this period that port development projects in the United States had lagged behind those of other developed countries and that this was contributing to our severe trade imbalance.

At the same time, this was a period in which there were large budget deficits and objections to using Federal funding to address this problem, and it was one that, as Judge Mayer pointed out in his dissenting opinion, engaged the attention of Congress over an extended period involving three Congresses and more than 4 years of numerous hearings and other activities, and one of the solutions to the funding problem was to craft a system of user fees that would avoid the need for funding out of general revenues.

Unidentified Justice: Sort of similar to the last case, isn't it, trying... finding someone else to pay.

[Laughter]

Mr. Wallace: Well, in this instance there was a practical problem to be addressed.

Improvements were needed and the beneficiaries of these facilities could, under court precedent, be charged user fees to defray the costs of providing these--

Unidentified Justice: Can you tell us--

Mr. Wallace: --facilities for their commercial benefit.

Unidentified Justice: --Does the record show, or are there statistics that we can examine to determine how much of this tax is paid by people who are exporting in contrast to those who are just shipping from point to point in the United States?

Mr. Wallace: I don't... off-hand, I'm not able to point to a breakdown in the statistics in the record, not... certainly not in what we've reproduced in the joint appendix.

Perhaps my colleagues will be able to find something on that.

I do want to say that the... one of the most difficult problems that was faced in this massive legislative consideration was how to craft an equitable and workable system of user fees in the context of the multitude of difficulties that were brought to Congress' attention by various industry and port representatives as well as members of the executive branch.

Unidentified Justice: Mr. Wallace, one would have thought that if all this attention was devoted to user fees the enactment wouldn't have been called a tax.

Mr. Wallace: Well, it perhaps was unfortunate choice of nomenclature--

[Laughter]

--but as the Court's decisions do make it clear that nomenclature is not in itself controlling.

Now--

Unidentified Justice: Well, and also this thing is based on the value of the goods exported, isn't it?

Mr. Wallace: --That is correct.

Unidentified Justice: So that you have a little package of computer chips this big that takes no space in the ship at all, and it's going to result in a huge tax, but a big quantity of wheat, that actually does require a large ship to convey it and so forth, might pay substantially less.

Mr. Wallace: That is--

Unidentified Justice: The value might be less.

It's kind of an odd sort of a user fee, isn't it?

Mr. Wallace: --That is exactly correct, and if I may I would like to elaborate on this with reference to the legislative consideration of this very issue, but first I just want to interject in response to Justice Kennedy's previous question that on page 63 of the joint appendix there are some statistics that will shed some light on the question that he asked.

Now, we have in our references isolated from the massive record of legislative consideration portions which are themselves quite hefty that dealt quite specifically with the user fee problem and, with the Court's permission, I would like to turn briefly to some brief excerpts from a statement that Senator Hatfield made which encapsulates the difficulties and the reasons for the crafting of it.

It's worth--

Unidentified Justice: How would a statement like that bear on whether or not this is a violation of the Export Clause?

Mr. Wallace: --Well, I think it bears on the reasons why the particular kinds of objections that are being raised to the way the fee was crafted may be not aspects of the fee that actually disadvantage exports but to some extent may be aspects that were designed to be advantageous to exports, and also shows the sum of the serious economic dislocations that were sought to be avoided in trying to find an equitable manner of putting this fee together, and I--

Unidentified Justice: I think if you'd had 20 wizards sitting down and coming up with the best possible solution in their view to these sort of... if it violated the Export Clause it's still bad, isn't it?

Mr. Wallace: --Of course, we do not contend that the difficulties and the magnitude of the effort that Congress put in would excuse a constitutional violation, but we do contend that it is too facile for others to contend that a court should ignore these aspects of the legislative consideration and merely hypothesize whether theoretically it could think of a system that might seem more appropriate to the court, which is insulated from the legislative concerns that were before the Congress.

Unidentified Justice: No, but you're talking about a user fee of harbors.

You'd think that would have something to do with the ships and the tonnage that's required and how deep the harbor needs to be and how big the dock has to be, and that turns on how large the ship needs to be, and this doesn't bear any relation to that.

Mr. Wallace: Well, that is part of the reason that it took that many years for the Congress to craft a solution, because they started off with some of those same assumptions, but found that they couldn't work it out that way for very serious reasons.

Unidentified Justice: Mr. Wallace, you've piqued my curiosity.

Why don't you read us that material you wanted to tell us about.

[Laughter]

Mr. Wallace: All right.

These are brief--

Unidentified Justice: Put it in for what it's worth, Mr. Wallace.

[Laughter]

Mr. Wallace: --These are brief excerpts of what Congress thought it was doing and why, and I might interject a few comments as I go along here.

In Senator Hatfield's statement, and it's in this hearing called User Fees for Ports and Waterways that we cite at the bottom of page 4 of our brief, he starts off pointing out we have not had a major authorization in this area for 15 years.

There are many economic and political reasons for this delay, but the resolution of the user fee component is a key element in getting a bill to the floor and passed.

5 years ago I convened a bipartisan group to explore legislative proposals addressing the expectations of the administration for user fees while taking into account the economic realities of the navigation economy and the users of the Nation's waterways.

Over that period I've introduced three separate and distinct proposals, one of which he explains became the bill that Congress later, shortly thereafter enacted.

He then explains, we reserved, meaning rejected in context, user fees based on tonnage because they disproportionately would effect bulk cargo marketability when compared to their impact on containerized cargo.

Unidentified Justice: What State was Senator Hatfield from?

Mr. Wallace: Oregon.

Unidentified Justice: A lot of timber.

Mr. Wallace: He was talking about a bipartisan group--

[Laughter]

--that spent years of study on this.

He was not... these are not views stated individually.

Unidentified Justice: No, but doesn't his statement boil down to saying that a fee which is a real user fee is going to have an economic impact that we don't want.

Isn't that what it boils down to?

Mr. Wallace: Well, it depends... I mean, it's not a real user fee... tonnage is not the only measure of economic value that someone secures from facilities in these days of containerized--

Unidentified Justice: It's a measure of use, isn't it?

Mr. Wallace: --It is a measure--

Unidentified Justice: Isn't it closer to being a measure of use than value?

Mr. Wallace: --It is a measure of use.

If I may just, in answering this, the very next sentence says that a fee based on tonnage also would disadvantage export-dependent ports in contrast to import-dependent ports.

One of their concerns was that our export trade would be hurt by a user fee based on this.

Much of our export was and is bulk commodities, grains, iron ore, which was having difficulty competing in international trade from the Great Lakes ports, which were suffering some depression at the time, lumber, as is pointed out, and other wood products.

The bipartisan group also rejected a port-specific approach to fees because it would have the effect of disadvantaging ports with higher operation and maintenance costs and could cause consolidation of port facilities to a few super ports.

This could have severe economic implications for scores of communities across the country.

So then he explains that the approach they finally chose to adopt is a nationally uniform single-tier fee based on a percentage of cargo value, and this ad valorem concept, as he explains it, equitably balances containerized versus bulk cargoes, places all ports on an equal footing, and does not affect the marketability of any product or commodity.

It also treats all coastal ranges of the continental U.S. in the same manner, East and West Coast, Great Lakes, and Gulf Coasts.

Unidentified Justice: Mr. Wallace, I guess--

--And if they pay for it out of the... suppose they pay for it out of the highway trust fund.

It's part of transportation.

Is the gas tax now... it's really a user fee.

Is that right?

Mr. Wallace: That is--

Unidentified Justice: I mean, I guess... all your arguments would say, we don't even have a gas tax.

We have a highway user fee, is that right, even though they call it a gas tax.

Mr. Wallace: --It is very similar.

In fact, the trust fund--

Unidentified Justice: So if we accept your argument there is no gas tax.

It's really a highway user fee and if, in fact, they decided to pay for the ports out of the highway trust fund, then the whole thing's a highway user fee.

Maybe it's an income user fee, a facilities user fee, income tax is really a user fee for using the country's facilities.

[Laughter]

How do you draw the line?

Mr. Wallace: --We wouldn't go this far, but the particular concern that Congress was addressing here was the disadvantage to the commercial use of our ports and to commerce resulting from the outmoded nature of the facilities.

Unidentified Justice: We can get rid of all the disadvantage to exports by putting the whole thing in the income tax.

That doesn't make the income tax a user fee.

Maybe it does.

Mr. Wallace: No, of course not, but it would mean that it would become a matter of general funding.

In any event--

Unidentified Justice: Mr. Wallace, I thought that when we made an exception from the constitutional prohibition of Federal taxes on exports, when we enunciated an exception for user fees, I didn't think that meant any charge imposed on users.

I... that would make it no limitation at all.

So long as you impose the tax through users, you can tax exports as much as you like.

If that limitation is to have any bounds at all, it seems to me we must mean by user fee a charge that is based upon the degree of use of the port.

Mr. Wallace: --Well, I think this Court's jurisprudence in distinguishing taxes from user fees shows that it is a more variegated distinction than that.

Unidentified Justice: Not in the Export Clause field.

In other... you're referring to cases that deal with other provisions of the Constitution, not the Export Clause.

Mr. Wallace: Well, those cases all had their root in a case called Pace v. Burgess, which was an Export Clause case.

Unidentified Justice: And in Pace the Court was at pains to point out that the charge there was not an ad valorem charge.

Mr. Wallace: That is true, but it also made a... but ad valorem charges have since been upheld as permissible methods of user fees.

Unidentified Justice: Not under the Export clause.

Mr. Wallace: But in other contexts where constitutional objections were raised.

Unidentified Justice: But constitutional objections may be quite different in different cases.

We have here a very specific prohibition, and the... you know, the Pace case, the Fairbank case deal with those particular... that particular clause.

I'm surprised you... perhaps it's our fault that you haven't been able to get to those cases yet, but--

Mr. Wallace: Well, I--

Unidentified Justice: --we know the Congress--

Mr. Wallace: --I'm trying to set this up in context.

Unidentified Justice: --Yes.

We know that Congress gave its all on this thing, but now let's look at the law.

[Laughter]

Mr. Wallace: Yes.

Yes, and I have to add one further consideration that inhibited the legislative consideration, and that was it was all done against a backdrop of awareness of our international trade relations and international agreements with our trading partners, which also do not supersede constitutional limitations, but they're relevant to whether Congress was going to be able to solve this user fee question.

Because those agreements... it was GATT at that time, and now WTO... in which there have been reciprocal reductions of tariffs, those... there are expectations and obligations that prevent members in those agreements from discriminating against the foreign industry in favor of the domestic industry.

And even though the measure adopted here was one that generally would be favorable to exports as against imports, the ad valorem method, for reasons that Senator Hatfield explained, that could be defensible under these agreements, but to charge user fees to imports and not to exports in these same harbors could be a basis for objections and retaliation by our trading partners as a disguised form of raising our tariffs again, and--

Unidentified Justice: Mr. Wallace, is that why you suggested that maybe this... if we ruled against you the whole thing would fall?

That sort of surprised me.

In page 18, footnote 8 of your brief you say that if the decision of the court of appeals stands, that would effectively abolish the trust fund.

It would void the harbor maintenance tax in its entirety, and I had been thinking up till now, well, no, it would only excise the export feature of it, and now you're suggesting well, maybe the import would also fall?

Mr. Wallace: --No, we really meant that in context only for exporters, but there is... I don't want to suggest that this would not be severable, but the concern about possible retaliation by our trading partners in saying that we've in disguise raised our tariff rates again and so they're going to raise theirs, that would not only affect the public interest in our balance of trades, but it would directly affect exporters from this country.

It would be something that would burden exports from this country.

Unidentified Justice: But it would be applied to them the same way it would apply to shipping, say, from New York to Texas?

Mr. Wallace: No.

I'm talking about retaliation by our trading partners.

If they then raise their tariffs, that makes it harder for industries in this country that wish to export to be able to export.

Unidentified Justice: Well, I take it it's more serious than that.

If we strike down the export provision and require refunds, but the importers can't get any refunds, then we're in violations of the agreement.

Mr. Wallace: Well, I wouldn't go so far as to say we're necessarily in violations, although a foreign country, one of our trading partners might make such a claim before the World Trade Organization, but they also could use this as a reason to impose retaliatory measures.

Congress was faced with a very complex problem here.

The Constitution is designed for modern commerce as well as for the commerce that was known at the time that these provisions were adopted, and we think that the court of appeals was right in pointing to this Court's user fee jurisprudence which has been developed in detail in fields other than the Export Clause after Pace v. Burgess.

Unidentified Justice: Well, if a provision is under alternative 1 a tax on imports and exports, it doesn't seem to me that that makes it any more or any less a user fee under any other alternative.

Mr. Wallace: Well--

Unidentified Justice: In other words, you're... I understand the problem the Congress was faced with.

It can't tax imports... exports.

That doesn't mean that if it taxes imports and exports it's no longer an export tax.

It's still the same thing.

It's still an export tax.

Mr. Wallace: --Well, we understand that from the IBM case if this were a tax, and that is why we are arguing that this is a permissible user fee, which is one of the arguments we had made right along in the case and, indeed, had always been our principal argument, and it satisfies the basic classic attribute of a user fee that has been developed in many aspects of the Court's jurisprudence.

The funds are all impressed into a trust.

Unidentified Justice: Well, if it were imposed, let's say, on the ship... the ships, the owners of the ships or the vessels, and a charge for using the docks or the harbor, which the vessel owners could then pass on in the form of costs to the users of their vessels, I think you'd have a good argument that it's a user fee, but the nature of this makes it awfully hard to see it as a user fee.

Mr. Wallace: Well, the Court in the Evansville-Vanderburgh case did say that it seemed to the Court in that context to make no difference whether it was assessed on the airline or on the passenger, because it came down to the same thing.

The costs were to be passed along to the passenger.

There was a very practical reason for asking the shippers to be the ones to make the payment, and that was that the carrier would not be in a position... once Congress decided that the ad valorem measure was the only equitable one that they could hope to impose, the carriers would not be in a position to know the value of the cargo.

And one of the principles that this Court has recognized repeatedly in giving legislative latitude in the crafting of user fees is that you don't want to add administrative expenses that will make the fee more burdensome and more onerous for everybody, that there are virtues in keeping it simple.

And the Customs Service is there, was a resource that could be drawn upon that deals not with the carriers but with the owners of the goods with the shippers one way or the other, and Congress tried to craft this in a manner that would impose the least burden and would avoid severe economic dislocations in the country.

Unidentified Justice: Mr. Wallace, can I ask you, do we have a definition of user fee?

It seems to me your argument is that as long as the fee is paid by users and the money is used for the purpose of improving ports, that's enough.

Mr. Wallace: That is enough to make it a user fee, and it's a permissible user fee.

Unidentified Justice: But is that... is... do I correctly state your position, and if that's true, could you impose a 10-percent tax on the income of every user and then put it in this fund?

Mr. Wallace: Well, if it... that would have much more difficulty meeting this Court's criteria for what is a valid user fee.

Unidentified Justice: Well--

Mr. Wallace: There are the three-part criteria, including that it must not be excessive in relation to the cost to the Government of providing the benefits that are accorded--

Unidentified Justice: --Oh, but of course--

Mr. Wallace: --to those contributors.

Unidentified Justice: --Then don't you bump into Justice O'Connor's position that if some particularly valuable shipment is sent the cost for that particular shipment is really excessive in terms of the use that is gotten for it?

Mr. Wallace: Well, you know, that is... an ad valorem system, any system is going to have some applications that could be improved upon in a more Utopian scheme, but Congress reasonably concluded that those whose cargo in the aggregate was more valuable were getting greater benefits in terms of enhancement of value from the improvement in facilities that was being provided in order to promote their commerce, the commerce of the users.

Unidentified Justice: Mr. Wallace, tell me why it is not true that any definition of user fee, which simply defines it as a... you know, a fee imposed on users, and which does not limit it to the cost that is incurred by the facilities in providing the use, any such definition will be totally ineffective in preventing the taxation of exports, because you could always... I mean, it comes to the same.

You call it a user fee and impose an ad valorem tax, which is what has happened here.

Mr. Wallace: The three-part test has to be met.

Unidentified Justice: In fact, they didn't even call it a user fee.

They called it a tax.

Mr. Wallace: The three-part test does have to be met that this Court specified in the Massachusetts case.

Unidentified Justice: Which wasn't an export tax.

Mr. Wallace: No.

Unidentified Justice: In fact, none of your examples of user fees which were upheld have come from the prohibition against a tax on exports.

Mr. Wallace: We recognize that, except for the route in Pace v. Burgess.

Unidentified Justice: And Pace v. Burgess, as I say, pointed out expressly in the Court's reasoning, one of the reasons they upheld it, it was not an ad valorem tax.

Mr. Wallace: That is true, but ad valorem taxes have been upheld as user fees--

Unidentified Justice: --export tax.

Mr. Wallace: --in Sperry and in Capital Greyhound Lines referred to in Evansville-Vanderburgh in the discussion of Capital Greyhound Lines as one permissible approach.

Unidentified Justice: Mr. WAllace--

Mr. Wallace: So those are three decisions of this Court that have recognized that as a basis for user fees--

Unidentified Justice: --Mr. Wallace--

Mr. Wallace: --in a proper context.

Unidentified Justice: --this was in the pipeline when IBM was decided, so... and my question is, is there anything else in the wake of the IBM decision that's in the lower courts now that we might want to take account of as we decide this case?

Mr. Wallace: No.

These have been the main feature that awaited the decision in IBM, as we pointed out in the IBM briefing itself, that these cases were pending as one of the reasons why a decision was needed in that case, and then the arguments were adjusted accordingly.

But it is true that the Court has repeatedly recognized that even exporters can be charged fees for pilotage, for wharfage, for other facilities that are provided, and the line has to be drawn somewhere.

Exporters are not exempt from paying their own way in commerce the same as other users of the facilities of commerce, and the best guidance for drawing the line has been the test that the Court has developed in protecting all constitutionally protected interests.

I'd like to reserve the balance of my time.

Unidentified Justice: Very well, Mr. Wallace.

Mr. Atwood, we'll hear from you.

ORAL ARGUMENT OF JAMES R. ATWOOD ON BEHALF OF THE RESPONDENT

Mr. Atwood: Mr. Chief Justice, and may it please the Court:

First, I'd like to supplement the answer to Justice Kennedy's question about what data is in the record.

Also in the appendix at page 97 is some more updated material about the relative charge on exports and imports in domestic commerce, and in the amicus brief of the Aluminum Company of America they had the most recent, 1997 data.

Basically it tells the same story, and that is that exports have paid between 25 and 30 percent of this tax over the years, and the amount that the exports now pay is less than the annual surpluses accumulated, so you could eliminate exports entirely from this tax and there would still be more revenue coming in than the Government is spending on harbor maintenance.

Unidentified Justice: That would translate into a tax, then, on imports only, and I think would raise serious discrimination problems under trade agreements.

Mr. Atwood: Well, this... if there is an international issue there, it can be solved in the same way the export problems can be solved, which is to make this a legitimate user fee.

I think the foreign Governments are concerned by the fact that they thought they had negotiated ad valorem duties of a certain level and now the United States is imposing ad valorem charges on top of that, and that's the problem internationally, if there is one, so a valid user fee approach here I think would solve both the export problem and the import problem.

Unidentified Justice: In fact, I guess the fund has quite a surplus in it.

Mr. Atwood: It has more than a billion dollars and is expected to hit $3 billion in just a few more fiscal years.

Unidentified Justice: That money isn't... it's just not lying there.

I assume the Government is using it for other purposes, meanwhile.

Mr. Atwood: Exactly.

That is one of our--

Unidentified Justice: The way it uses taxes... the way it generally uses tax money.

Mr. Atwood: --That is one of our objections to this user fee classification.

The harbor maintenance trust fund is simply an accounting entry.

Revenues under this tax are treated as on-budget, so that every dollar that comes in offsets obligations to raise taxes for discretionary spending under the budget control process.

There is a transfer to the trust fund which is a nonevent for budget purposes.

It's simply an accounting entry, and then any expenditures actually made for harbor maintenance--

Unidentified Justice: There's enough in there to pay for the coal miners and their dependents?

[Laughter]

Mr. Atwood: --Any appropriation for harbor maintenance has to follow the same process as if there were no trust fund.

There has to be a bill from both Houses of Congress signed by the President and Congress is free to appropriate as much or as little money as it would like for harbor maintenance, irrespective of what's in the trust fund.

I'd like to address the Government's argument that Mr. Wallace started with that the... this tax... and I hope I can call it a tax, because that's what Congress called it... was a result of a very complex, delicate legislative process and important compromises were made and sophisticated judgments as to what was possible and what wasn't possible.

Unidentified Justice: Mr. Atwood, before you do that, may I ask if you would tell us what you think are the essential components of what one could legitimately call a user fee, because I think you told us, you're not arguing the export clause rules out user's fees, but it has to be legitimate.

Mr. Atwood: Right.

Unidentified Justice: And Mr. Wallace, if I understood him right, said, well, it's a tax on a user and it has to meet those three standards.

Mr. Atwood: We are not arguing that there is no such thing as a legitimate user fee.

In the context of the Export Clause at least, because of history, because of the unqualified nature of it, because of this Court's precedents, we think the class of user fees has to be defined strictly and narrowly.

There must be a demonstrable service provided to the exporter on that export shipment, an identifiable Government service that is being provided to the exporter, and the charge must bear a very close relationship to that service, particularly where a fee is compulsory in nature.

Unidentified Justice: For the cost of that service.

Mr. Atwood: For the cost of that service, exactly.

Unidentified Justice: Do the costs here include fixed costs for dredging the harbor originally?

Is it all maintenance, or is it--

Mr. Atwood: No.

Capital costs--

Unidentified Justice: --Well, there is a tradition... there is a tradition of something called value of service pricing, where you charge somebody for the fixed cost in relationship to the value of the commodity that uses the service.

That's... the ICC did that for years, and--

Mr. Atwood: --I think the--

Unidentified Justice: --I don't know whether that makes it a great thing, but there is that tradition.

Mr. Atwood: --Once you're getting into value of service I think that is crossing the line into a tax.

Unidentified Justice: Well, nobody would have thought ICC railroad freight car rates were taxes.

They would have said that those are... that's simply a way of pricing the railroad line and, indeed, they have it in the telephone service business right now, where you pay lower cost of residency, and... I mean, there are all kinds of things like that where fixed costs are divided in relationship to the value of the service rather than the cost of the service to the person who's using it.

Mr. Atwood: Well, in deciding this case, this Court need not anticipate every possible cost theory that might be advanced, but an ad valorem tax based on a Nation-wide program, an infrastructure program, is about as far from costs as is possible, and it is feasible, I think, for the... for Congress to have come up with a much more sophisticated targeted user fee, and that is proven by, in the very same legislative package that included the harbor maintenance tax, there was the harbor development tax, which was the State analogue.

Under the Import-Export Clause Congress has authority to, notwithstanding the Import-Export Clause prohibition, has authority to authorize State charges of various sorts, and the same legislation included the harbor development tax, which is... the key provisions are in the appendix to our brief, where Congress said, okay, States can impose harbor dues, notwithstanding the Import-Export Clause, but they have to be on a project-specific basis, they have to... there has to be an identifiable project, they may not impose the dues until the project is up and running and providing services to the shippers, exporters or importers, the costs have to be limited... the fees have to be limited to the cost of the project, and you have to discriminate between which vessels are actually using the project and which are not.

This is in the same statute that included the harbor maintenance tax.

Unidentified Justice: Is this imposed on vessels or goods?

Mr. Atwood: That is not specified in the statute.

It says the local... the States and municipalities can consider either approach, but they may not impose charges if the vessel is of a type that would not have benefited from that project.

For example, a shallow draft vessel, regardless of what it's carrying, may not be charged for deep dredging when it did not need the deep dredging, so it's an example of an approach that is obviously far closer to a justifiable user fee, and it was in this very legislative package.

It can be done.

You know, also, as the quotations that Mr. Wallace gave us indicate, this was a difficult political process, to be sure.

The Framers were worried about how exports would survive in the political process.

That's why we have an Export Clause.

This is clear from the constitutional debates.

There was concern that, if you left these matters to Congress, that in the give-and-take of the political process exports would not come out favorably, so, instead of waiting for Congress to include exemptions in statutes, and there are a lot of exemptions in this statute, Congress... the Framers put the exemption in the Constitution itself, and that exemption is not being honored here.

There is a long tradition under the Export clause of broad liberal construction.

The Court has said that in Fairbank, it said it most recently in IBM, it said it in A. G. Spalding, and the broad construction to which the Export Clause is supposed to be given would be completely undermined here by an ad valorem tax.

Unidentified Justice: I'm not sure what your answer was to Justice Breyer's question.

There are many ways of allocating costs.

In Justice O'Connor's example, I suppose a valuable shipment needs some extra security guards and a safe warehouse facility.

Maybe that's included in the act.

It seems to me that ad valorem is certainly the simplest way to measure the benefit that the person is getting.

Now, maybe that's not a use tax.

Are you saying that a use tax can never be measured by the benefit that the user derives?

Mr. Atwood: I believe a proper user fee should be framed in terms of the cost of the benefit and not the benefit.

The examples you gave, first of all, don't involve Federal services.

The Federal Government does not provide any marshalls at ports.

That's separate altogether.

And the lower courts, I think they both considered this question of whether ad valorem is a reasonable measure, even of benefit.

They gave the Government the benefit of the doubt and said, even if we analyze this on the basis of benefits, ad valorem is irrational, because benefits have to do with the profitability of the shipment, not its total value or--

Unidentified Justice: That argument runs into Justice Breyer's point.

I mean, we've considered it rational enough for regulatory pricing.

You know, value-of-service pricing has been common, and we've never thought it was irrational.

And even if you--

--It's rational enough.

I think your point has to be that it's simply not compatible with any limitation on the taxation of exports, because once you go to ad... it comes to the same.

Except that if you relate it to costs... say you're putting in a new lighthouse at the harbor entrance, which would benefit everybody who uses it, and if the total amount collected doesn't exceed the cost of the lighthouse, doesn't that satisfy your cost test?

Mr. Atwood: --A port-specific charge for a lighthouse.

Unidentified Justice: Correct.

Mr. Atwood: That would... sounds to me like a proper user fee, although I still wonder--

Unidentified Justice: And say... and it's measured by those who use it, by the value of the goods shipped.

Mr. Atwood: --I would think the proper approach is not to measure it by value but to measure it by--

Unidentified Justice: Well, your ceiling--

Mr. Atwood: --numbers of passages past the lighthouse, or some--

Unidentified Justice: --Number of calls on the port.

Mr. Atwood: --Number of calls at the port, exactly, and that's how State taxes are often allocated between ports.

You measure relative port days.

Ad valorem really just slides you right into wealth transfers and taxing of value, and particularly so when you do it on a Nation-wide basis, where the costs of dredging in Oregon are paid for by shippers on the East Coast.

So I... and given the history of this clause and the purpose for which it was intended to be there, which is to protect exports from the vagaries of the political process, I think it does require a broad construction.

If there are no--

Unidentified Justice: There was a jurisdiction point.

Do I understand correctly, if it... if the CIT is the right place the cases that were started in... what is the proper title now, the CFC?

could be transferred under 1631 and that would take care of the statute of limitations?

Mr. Atwood: --That doesn't affect my client--

Unidentified Justice: Because you started out on the CIT--

Mr. Atwood: --so we do not take a position on the--

Unidentified Justice: --You don't take any position on that?

Mr. Atwood: --On the transferability of cases from that other court, because in this case it's clear that the CIT... conceded by both sides the CIT and the Federal Circuit had jurisdiction.

Unidentified Justice: Thank you, Mr. Atwood.

Mr. Wallace, you have a minute remaining.

REBUTTAL ARGUMENT OF LAWRENCE G. WALLACE ON BEHALF OF THE PETITIONER

Mr. Wallace: If itemization requirements are carried too far, and you get into an example for... where wharfage capacity has been increased, does that mean that only the users of the new wharves can be charged user fees?

If the channel has been deepened and somebody could have gotten along with a shallower vessel but because of the deepening of the channel had to use the larger vessel, does he have to bear part of the costs?

The Constitution may not prohibit Congress from causing serious economic dislocations in exercising its power, but the Court should be hesitant to require Congress to cause serious economic dislocations by not allowing it the latitude that it needs in fashioning an equitable method of devising user fees.

Yes, Congress does have to address the surplus that is accumulating in this fund, but all of the account is impressed for operation and maintenance of the harbors and for no other purpose, and that... and those funds are still available for that.

Congress has been reluctant to expand the authorizations to NOAA, for example, or to the Coast Guard, because the more aspects of navigation are brought under this fund while litigation is pending, the more it's argued that these are general expenditures.

Chief Justice Rehnquist: Thank you, Mr. Wallace.

The case is submitted.

Attribution:

The OYEZ Project

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