Famous and Important Tax Cases: Part I

In episode 29 of How Tax Works, Matt Foreman discusses important and relevant tax cases, noting that there might be a patriotic duty to pay your taxes due, the power of substance versus form arguments, and how hedges are taxed.

How Tax Works, hosted by Falcon Rappaport & Berkman LLP Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions.

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Transcript

Matthew Foreman [00:00:00]:
Hello, and welcome to the 29th episode of How Tax Works. I'm Matt Foreman. In this episode, I'll discuss famous, important, and often misunderstood and misapplied tax cases. Some Supreme Court, some district court, all over the place. But I think they're ones that are important. And so we're. I'm going to waste some time and hopefully you'll enjoy listening to hear me talk about them.

Matthew Foreman [00:00:31]:
Learn something to. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising, and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions we all make. Before we get started, a few administrative things. This episode, I'm gonna be really honest. I'm not totally sure how long it's gonna take, whether it's gonna be two or three.

Matthew Foreman [00:01:03]:
So the next one's just gonna be a continuation. The next one after that might be a continuation of a continuation, and the one after that. So either the 31st or 32nd episode is gonna be revisiting the passive activity loss Rules under section 469 in the Real estate context, particularly with rental real estate. I think that's a really important one. I kind of skirted along it. Didn't really mention it. Did that on purpose. May have gotten called out for it.

Matthew Foreman [00:01:29]:
We'll talk about that, but I think that's an important one. If you have any questions, comments, or constructive criticism, you can email me at my FRB email address. Our upcoming webinars and speaking engagements are on the How Tax Works landing page on the FRB website. All right, let's talk about important tax cases. These are cases that I think practitioners should keep in their proverbial toolbox. Um, I don't know too many tax lawyers who carry around toolboxes, but they're ones that I think are broadly applicable, and I think they're ones that are useful in a lot of different contexts. Some of them have really specific fact patterns, but because of that, you know, or I should say, despite that, they're actually pretty applicable in a lot of different areas. The first one is possibly the single most famous tax case of all time.

Matthew Foreman [00:02:21]:
There is a Supreme Court case, but the language at issue really comes from a Second Circuit decision. And if you think I'm going Cohan, you're wrong. Although that's a really important case. Helvering v. Gregory. I'm going to drop Citations on these, so you can read them if you want. 69 Federal Second 809 Second Circuit 1934. The judge is Billings Learned Hand.

Matthew Foreman [00:02:44]:
He went by Learned Hand. Fascinating to me that a person would be given the middle name Learned and then choose to go by it. Maybe as a child he was given that and sort of ran with it. One note I have is when you talk about cases in general, you need to talk about the taxpayer or the unique name. Both Helvering and Gregory are fairly unique names. Saying something like the Smith case, not terribly helpful guy Helvering. His middle name was Tressilian. Don't know why lost the time.

Matthew Foreman [00:03:14]:
He was the commissioner of internal revenue from 1933 to 1943. So he comes up a lot in tax cases as one would expect. It's when they named the commission of revenue. Now it's just commissioner. And he was also afterward a district court judge from 43 to 46. He's from Kansas. That's where he's district court judge. He died while.

Matthew Foreman [00:03:33]:
While serving. I hope not literally as a district court judge. And that that was the end of that. This case is incredibly broadly quoted. I'll read. I will literally read the quote from the court case. And I want to let you know before I even get into anything that if you're ever in a situation with a tax advisor and a tax advisor quotes from this case or cites this case for anything other than the proposition that you should not do what they're telling you to do or what someone else is telling you to do, you should get up and walk out. If someone who's not a tax lawyer saying I'm not giving you tax advice, but and they quote this case, you should walk out absolutely unequivocally.

Matthew Foreman [00:04:13]:
And I hope you'll get why. So the taxpayer who is Mrs. Gregory, she owns shares of a corporation and the corporation owns shares in Monitor, which is also corporation. I use the word corporation because they're both C Corps. They were not S Corps. She could have sold Monitor for a large profit. However, she made the decision through her tax advisors. Where tax advisors determined that the corporation, the parent, would have to pay tax and then there'd be a distribution to Mrs.

Matthew Foreman [00:04:38]:
Gregory and she'd pay another level of tax. Corporation, two level tax. Right. That's how it works. The taxpayer instead formed a new company. Averill or Averill, I've heard both. And did a tax free reorganization such that the Monitor shares were now owned by Averill, which was owned by the taxpayer. I should note that the corporation the parent that previously owned Monitor also owned other businesses, other assets which would have made this next step impossible.

Matthew Foreman [00:05:04]:
The taxpayer then wound up avarill liquidating it and distributing the assets which were the shares in monitor, to Mrs. Gregory, who then sold the shares in Monitor. Right. The Board of Tax Appeals, the forerunner to the Tax Court, held for the taxpayer, the Second Circuit, and then the Supreme Court held for the irs. I'm going to read it and then I'm going to kind of go on a bit of a discussion of it. And I think it's important and I apologize for reading. I take great pains to not read more than a sentence at a time. It's really boring.

Matthew Foreman [00:05:35]:
But this is one of those ones. First off, learned hand for anyone who went to law school. You know the name because you read a lot of his cases. Extraordinary writer, one of those writers that you read and you just say, wow, you know, 1% of 1% of 1%. Just an amazing, amazing writer. He said, we, which is the Second Circuit, we agree with the board and the taxpayer that a transaction otherwise within an exception of tax law does not lose its immunity because it is actuated by a desire to avoid. Or if one choose to evade taxation, anyone may so arrange his affairs that his taxes shall be as low as possible. He is not bound to choose that pattern which will best pay the Treasury.

Matthew Foreman [00:06:19]:
There is not even a patriotic duty to increase one's taxes. Okay, cites Isham, Supreme Court case. Boland, which is Supreme Court case. That's what they all read. That is what's called dicta, not dikka. You know, the former coach for Pittsburgh Steeler, Dallas Cowboy, former coach of the Bears and later the New Orleans Saints made that awful trade to draft Ricky Williams. That's irrelevant and I'll tell you why I'm skipping a sentence. And then it says, nevertheless, it does not follow that Congress meant to cover such a transaction.

Matthew Foreman [00:06:50]:
Not even though the facts answer the dictionary definitions of each term used in the statutory definition. It is quite true, as the board has very well said. Again, board is the irs or I'm sorry, board is the tax Court, as the board has very well said that the articulation of a statute increases the room for interpretation, must contract. What that means is the. The longer the statute, the less you can wiggle around it. But the meaning of a sentence may be more than that of the separate words, as a melody is more than that of the notes. And no degree of particularity can ever obviate recourse to the setting in which all appear and which all Collectively create. The purpose of the section is plain enough.

Matthew Foreman [00:07:36]:
Men engage in enterprises, industrial, commercial, financial, or any other might wish to consolidate or divide or to add to or subtract from their holdings. Substransactions were not to be considered realizing any profit because the collective interest still remained in the solution. But the underlying presupposition is plain that the readjustment shall be undertaken for reasons germane to the conduct of the venture at hand, not as an ephemeral incident egregious to its prosecution. To dodge the shareholders taxes is not one of the transactions contemplated as corporate reorganizations. What they're saying is you need a business purpose and you must have a continuity of interest to undergo a tax for your organization. That's what the holding is in Gregory really important. The line, he is not bound to choose that pattern which will best pay the Treasury. There's not even a patriotic duty to increase one's taxes is literally irrelevant.

Matthew Foreman [00:08:32]:
If anyone cites the first without pointing out the second, walk away. I will now tell you a story which is really important. Right? I was in a class in my LM program at nyu. Someone in my class, a student, said, first off, what about the helvering case? Which invariably in and of itself makes me go, well, this person hasn't totally thought through the argument and doesn't know what they're doing, but here we are. And secondly, they then quoted, misquoted, but they paraphrased fairly accurately the idea that there's not even a patriotic duty to increase your taxes. However, they didn't read what was literally, you skip one sentence and then there's the next part that I read. And I think that that's the really important thing to understand from Gregory. All right, ignore.

Matthew Foreman [00:09:13]:
Basically ignore the first step of the transaction. Because while you can do each step in the transaction, you cannot. One word cannot. Not allowed. Okay? You are not allowed to do what you did because each step works. But if you look at it, what is the substance? The substance over form is all you started with was you now have the parent company and that's it. So there should have been two levels of tax. Your method of doing that would work.

Matthew Foreman [00:09:41]:
I must note that how they did it in Gregory wouldn't work today. There's still two corps, so it wouldn't actually really work with what they wanted to do. The rules under 368, which I went through the immediate second, sales problematic. This is a very old case, okay? This is such an old case that involved a tax year that things were a little different. But I Think Gregory is a really, really, really good first case to go through. And I think it's one that really, really discusses what's important. Okay. A lot of times a lot of the tax shelters and other similar things involve literal, overly literal readings.

Matthew Foreman [00:10:16]:
And that's where it gets problematic because the advisors will say, well, you can do it. And someone who's trying to get. You invest with that a lot of times, right, Invest in this. You'll get this right. 469 pass activity losses. Don't worry about that. You can do an hour here, an hour there. It's no problem.

Matthew Foreman [00:10:31]:
No, no, no. We listen to episode 13 or episode a couple go through it. And I think that's a really, really important thing to think about is that if you couldn't do the direct line, you're going to be problematic unless Congress or the Treasury Department or irs, whatever, through guidance, sub regulatory guidance, takes it and says you can do X. And that's the big. The next case I'm going to go to is eisner v. Macomber 1920, case 252 U.S. 189. I'm going to be honest, I did not look up who was commissioner of Internal Revenue at the time.

Matthew Foreman [00:11:01]:
I just didn't do it. I look it up for helvering because he's in a lot of cases. I think Eisner was, but I don't actually know. Anyway, so the taxpayer's first name was Myrtle. Love that name. Great name. Think of Mr. Myrtle.

Matthew Foreman [00:11:14]:
If anyone knows the reference. Congratulations. Outlandishly good movie. So the stock in question was Standard Oil. It had about a $20,000 value. This case decided 1920, but the tax year in question was 1913. This was actually predated the Internal Revenue code they had. In fact, I don't even think they had passed the constitutional amendment, let alone ratified at this point.

Matthew Foreman [00:11:39]:
So what Standard Oil did was what's called a pro rata stock dividend. Okay, so basically the way we look at it today is this is a stock split. Everyone owned one before you distributed one more share to everyone else. Now you own two. The IRS said, yes, this is taxable. How can you think otherwise? The tax lawyer said no. Before I owned $100 of value in the form of one share of stock. Now I own $100 of value in the share of two shares of stock.

Matthew Foreman [00:12:07]:
Not that different. Poor Myrtle. Right. The Supreme Court said, no, this is not taxable because you don't actually own anything else. And it must be pro rata, must be common stock. That's really important. If you were to do a dividend, a preferred uncommon could be problematic. If you're doing a non pro rata share distribution, some get stock, some get something else or some get stocks, some get nothing.

Matthew Foreman [00:12:27]:
That's problematic. That's just a distribution. Could be a dividend. Section 301 would apply. I think that's a really important case. Isaac v. Macomber. Still good law.

Matthew Foreman [00:12:37]:
Now it's codified, so not as big of a deal. All right, we're going to take a momentary break. I'm going to drink some water and we'll be back with Commissioner v. Danielson. All right, we're back with episode 29 of How Tax Works. We're going to talk about Commissioner v. Danielson, 378 Fed. Second 771 first.

Matthew Foreman [00:13:01]:
The first two are really old cases. This one is Third Circuit 1967. Not the newest, not the most recent, we'll touch, but still pretty recent. Pretty recent. There are a lot of cases that discuss this point. I'm only going to discuss this one. Only going to talk about Danielson. The taxpayer sold the stock of a company.

Matthew Foreman [00:13:18]:
The buyer insisted that there was a covenant not to compete when selling it to the shareholder, you know, say shareholders, the CEO could be in the industry, et cetera, et cetera. They allocated the purchase price in an agreement both to the shares of stock and the covenant not to compete. The taxpayer, who's Danielson, who's the seller, ignored the agreement, ignored the allocated purchase price, and in the return, a hundred percent of the stock was the capital asset. The stock, which is a capital asset and none to the company, not compete, which would have been ordinary income in the 1960s. I should note the disparity between them was 30 points, 30, 40 points. It was, it was even bigger than today. It was gigantic. So it really mattered.

Matthew Foreman [00:13:59]:
Basically, the idea was that the taxpayer, again, Danielson, was disavowing its own form and the agreement itself. So basically, what must you do if you're disavowing your own form? One, you must show strong proof. Okay? There's, there's a split circuit here. First, Second, Seventh, ninth Circuits, all say you have to show strong proof, okay, Strong proof that the transaction substance is inconsistent with its form itself. There's many cases I'm going to cite. Penn, Dixie Steel, Court vs. Commissioner 69 T.C. 837, 1978 case.

Matthew Foreman [00:14:32]:
And that one needs to show there's strong proof that the transaction substance is inconsistent with its form in certain other districts, okay, Such as in Danielson. Danielson's third Circuit. You must prove that the contract should be disregarded due to mistake, fraud, undue influence or similar grounds. Right? Includes 5th, 6th, 11th or fed circuit. It's a higher standard, right? One just said you got to show strong proof that the substance and this is how you should be followed. Then the other one says there must be misstate, fraud, undue influence or similar grounds. The tax code is really interesting on this because there's so many different circuits. Some still don't have decisions, but some say it depends on the circuit for appeal.

Matthew Foreman [00:15:12]:
So I think that's an interesting one. Generally speaking, any I think reasonable tax practitioner will say you need to follow the form itself, but there can be reasons that you can make substance over form arguments. All right, we're going to go to one of my personal favorite cases. Aerosmith v. Commissioner, 344 U.S. 6, 1952 case. This has to the best of my knowledge absolutely nothing to do with the band Aerosmith. Not even spelled the same.

Matthew Foreman [00:15:38]:
So I feel pretty comfortable without double checking that it's just a coincidence. It's a R R O W s M I T H not A E O s M I T H. So I use this case a fair amount. With regard to earnouts in deals, it is a consistency of character issue. So in this case, the shareholders liquidated, a corporation got capital gains treatment. They later had to pay money due to a judgment against the corporation by a creditor. So the shareholders paid and the shareholders said oh, this is ordinary loss because the judgment is a creditor. Ordinary loss under 160, 62, I'm golden.

Matthew Foreman [00:16:09]:
Supreme Court said no, no, no, no, no. Because the income was capital, so was the loss. So basically it is a again and I consistency of character issue. So I use it for earnouts. I use it a lot. So hypothetical, you sell some stock for $180 today, $10 a year for two years. Let's pretend there's no basis, right? Make the math easy. All capital gains or you sell you know, a partnership interest, a hundred dollars plus an earn out, you know, $80, $20 earn out.

Matthew Foreman [00:16:38]:
Right? That idea, the earn out has the same character ratio. So if you're selling C Corp or S Corp stock, then be most likely long term capital gains depending on holding period. And then you know, for a partnership, right, the $80 is going to have some ratio, right? Dealing with hot assets. So capital, there's some hot assets for capture, ordinary income items, etc. As the initial sale. So that's what it is. It's going to retain it. And that's the idea.

Matthew Foreman [00:17:03]:
Ret. Really, really important. I think case one that really goes deep into the idea of. Of thinking about what you're doing. Some people say, oh, well, they're. Now it's all capital. Because it's that. I'm like, no, no, maintain same percentages.

Matthew Foreman [00:17:16]:
Orish v. Commissioner 55, Tax Court 395, 1970. This is a partnership tax case. I talk about this one a fair amount, probably too much. There's a couple cases on this one. Orish is probably my favorite one on it because I think it's a pretty simple case to taxpayers. And before I get into this, this is. If you really want to read a much better discussion of this in the logical subchapter K by Professor Cunningham and Professor Cunningham, chapter five.

Matthew Foreman [00:17:40]:
They talk about. They break it down. You can read the case really easy, right? Anyway, so two taxpayers, 50, 50, 50, 50 owners, right? Partners. One has a positive capital count and one has a capital count of zero. They decide to liquidate the partnership. They just distribute. 50, 50. That's wrong.

Matthew Foreman [00:17:56]:
Okay. What you're actually supposed to do is you must distribute in a manner to drive the capital accounts to zero. And then 50, 50 orish was problematic. So 704B, you ever dealt with 704B gain was enacted due to Orish and other similar cases. People say, why not 704C? I'll tell you in a second. And it was created the concept of substantial economic effect. For the capital accounts to have substantial economic effect, you must liquidate them. Step one must be to push the capital accounts to zero.

Matthew Foreman [00:18:25]:
That has to be must, must, must, must, must, must. Must be the way you do it. All right, the next case, we're going to do two together. Frank Lyon and all stores. Frank Lyon is Frank Lyon v. U.S. all right? 435 U.S. 561, 1978.

Matthew Foreman [00:18:44]:
All stores. Realty Corp. 46 TC 363, 1966. All stores. Happen first, but I'll discuss it second. Second, who knows why not even alphabetical order. So a bank wanted a new building, but for regulatory reasons could not own the building. Why not? I don't know.

Matthew Foreman [00:19:00]:
It may have said it in the case, but I didn't really read it that closely for that part. And it doesn't really matter. It couldn't. All right, so Frank Lyon was an individual, even though Frank Lyon Co. Was. Was the actual taxpayer in this. And Frank Lyon, he owned Frank Lyon Corp. And he was on the board of the bank.

Matthew Foreman [00:19:17]:
And he said, look, guys, I got this. So the bank owned the underlying land. The bank built the building for $10 million and sold it to Frank Lyon for $7.6 million. Frank Lyon used $500,000 of cash and $7.14 million recourse note to buy the building over 24 years. There was a lease in which Frank Lyon Co. Leased the building to the bank for over 25 years. And the lease amount equaled the exact amount of note payments. And Franklin Court made little, very, very little profit.

Matthew Foreman [00:19:52]:
The lease could be extended via renewals automatically in it for 65 years. And once the note was fully paid, the rent decreased. Significant. What was really going on here, and this is really important, is that the lease was structured in a way so that Frank Lyon Corp. Was, was not out of money. And I understand why he's trying to help a bank. You know, he's on the board. He says, I can help this out.

Matthew Foreman [00:20:15]:
Nope. So the net. Right, the basically the rent equaled the note plus the note payments, plus 6%. This is a sale. Leaseback. There's a number of factors determined whether it's a leaseback, whether it's a real sale. And this is really important. What's going on.

Matthew Foreman [00:20:32]:
Okay, the first one is real multi party with different owners. So despite the fact that Frank Klein was on the bank's board, they are, they were different owners. In fact, even if he's a shareholder, even 2% shareholder or versus a hundred very different. Two, whether the taxpayer itself was independent from the bank and landlord. Whether the taxpayer was liable on the construction loan and the mortgage loan itself, whether GAAP or something similar was used. This case actually only referenced GAAP. Again, 1978 case. The world's a little different.

Matthew Foreman [00:21:01]:
Maybe everyone used GAAP or maybe it's like today and no one actually knows what gap is because it's just generally accepted. And then the taxpayer's capital was actually committed to the building. Right. You know, the bank built the building itself. So if there was an overrun, the bank was paying. So, you know, that became problematic. All stores, I think is just a much more interesting fact pattern. To be candid.

Matthew Foreman [00:21:22]:
Steinway and Sons sold its warehouse to all stores for $750,000, which was below market by about two and a half, $250,000. But then Styway and Sons used the building for two and a half years without rent. Right. So again, fair market value of the building is a million rent. Right. We don't know how much it is. Doesn't really matter. They sold it for 750 what the tax Court did was they recharacterized the sale very simply.

Matthew Foreman [00:21:46]:
Right. They assumed, and I think correctly, that the value of the building was a million dollars. Right. That's what the court determined. So that's easy. And then what the Tax Court did is said, well, look, if the value of building is a million dollars and they paid 750,000, how much must the rent be for those two and a half years? The answer's pretty easy. Can you. $250,000 the Delta.

Matthew Foreman [00:22:05]:
Between a million and $750,000, the actual amount. So I think it's really important to note that the IRS argued and the Tax Court agreed. And I actually think it's right. If the value is a million, $750,000 is the amount of the sale, the actual sale amount. Recharacterized million dollar sale, $250,000 rent. So there's ordinary income flowing the other way. Right. There's a companion case, style and sons.

Matthew Foreman [00:22:30]:
40. Let's see. I have this. 46TC375 decided, literally the next case. If you go through all the cases, same fact, same result, both Steinway and Sons and all stores sued and tried to overturn it and were unsuccessful. I don't totally understand why they both did it and why it wasn't consolidated. Nowadays. I think they'd actually consolidate it into one case.

Matthew Foreman [00:22:52]:
But I guess they didn't. And I don't know. I don't know. Anyway, so I'm going to take a little break here. This will be the end of the episode. That's the 29th episode of How Tax Works. I hope you learned something. I'll be back in two weeks with the 30th episode of How Tax Works.

Matthew Foreman [00:23:07]:
And I'm going to be discussing the same thing, but different cases. Famous, important and misunderstood tax cases. Now for the best song of all time.