BANK NOT REQUIRED BY TAX BENEFIT RULE TO RECOGNIZE INCOME FROM REFUNDS PAID TO SHAREHOLDERS.

BANK NOT REQUIRED BY TAX BENEFIT RULE TO RECOGNIZE INCOME FROM REFUNDS PAID TO SHAREHOLDERS.

Hillsboro National Bank was an incorporated bank located in Illinois, which imposed a property tax on shares of stock held in incorporated banks. Hillsboro paid the tax for its shareholders and claimed a deduction on its federal income tax return, pursuant to section 164(e), which allowed a corporation to claim a deduction for taxes paid on behalf of its shareholders and denied any deduction to the shareholders. Illinois amended its constitution to prohibit ad valorem taxation of personal property held by individuals. While the amendment was being challenged, Hillsboro continued to pay the taxes and claim the deductions. Eventually, the amendment was upheld and the state refunded the taxes directly to Hillsboro's shareholders. Hillsboro did not report any income from the refund, and the IRS determined a deficiency. In a consolidated case, Bliss Dairy was a closely held corporation that kept its books on a cash basis. Bliss deducted the price of cattle feed purchased during the operating year, under section 162, whether or not the feed was actually consumed; much of the feed remained at the end of the year. Two days into the new tax year, Bliss liquidated and distributed its assets, including cattle feed, to its shareholders. Section 336 allowed the tax-free distribution of assets in liquidation; Bliss reported no income from the distribution. The shareholders deducted the basis of the feed as an operating expense in the year received. The tax benefit rule requires the inclusion of income when events occur that are fundamentally inconsistent with an earlier deduction. Hillsboro and Bliss asserted that while the tax benefit rule requires the recognition of recoveries, no recovery occurred in either case. The IRS argued that the tax benefit rule requires recognition when previous deductions become inconsistent because of later events, whether or not there was a physical recovery by the corporation. The IRS determined deficiencies against both Hillsboro and Bliss. In an opinion written by Justice O'Connor, the Supreme Court held that the tax benefit rule required Bliss to recognize income but did not require Hillsboro to do so. The Court explained the purpose of the tax benefit rule as approximating a transactional accounting system, so as to eliminate some of the distortions created by an annual tax system. Application of the tax benefit rule does not require actual physical recovery, the Court stated, but does require examination of the specific Code sections and of the particular facts at issue. In the Hillsboro case, the Court reasoned, the events were not inconsistent with the goals of section 164, which allowed banks to deduct dividends by receiving a deduction for taxes paid on behalf of shareholders. The Supreme Court determined that the intent of Congress in allowing the section 164 deduction was to grant relief to corporations making the payments for their shareholders; Congress was not concerned with the ultimate use of the funds by the state. The Court cautioned that the tax benefit rule would only apply if the original payment was negated by a refund to the corporation. The Supreme Court stated that the distribution of the feed to shareholders was inconsistent with Bliss's earlier deduction. The Court explained that section 162 allows for the deduction of ordinary and necessary business expenses, but is premised on the consumption of the expensed goods. Disposing of or consuming an asset after it has been expensed, the Court noted, would be inconsistent with the earlier deduction. While section 336 allows the nonrecognition of assets distributed in liquidation, it does not eliminate all recognition. The Court reasoned, therefore, that Bliss was required to recognize the amount previously claimed as a deduction. Justice Stevens concurred with the Hillsboro opinion and dissented with the Bliss opinion, believing the taxpayers should have received equal treatment. He argued that neither corporate taxpayer recovered any part of its expenditure, and, thus, the tax benefit rule did not apply to either of them. In dissent, Justice Blackmun argued that, in both cases, the deductions were negated when the premises upon which they were based were destroyed. According to Justice Blackmun, neither of the taxpayers should have been allowed to retain the tax benefit of a subsequently inappropriate deduction, and both should have been required to amend their returns for the years at issue, rather than add income to subsequent returns. Justice Brennan dissented regarding Hillsboro, agreeing with Justice Blackmun that the majority improperly applied the tax benefit rule, because, ultimately, there was no tax on the bank's stock.

Hillsboro National Bank v. Commissioner, 460 U.S. 370 (1983) United States v. Bliss Dairy Inc., 81-930 (U.S. March 7, 1983)

In this 1983 case, the Supreme Court ruled that, though the tax benefit rule applies where events occur to render a prior deduction inconsistent with its intended purpose, it did not require a bank to recognize income from a refund paid directly to its shareholders.

Hillsboro National Bank was an incorporated bank located in Illinois, which imposed a property tax on shares of stock held in incorporated banks. Hillsboro paid the tax for its shareholders and claimed a deduction on its federal income tax return, pursuant to section 164(e), which allowed a corporation to claim a deduction for taxes paid on behalf of its shareholders and denied any deduction to the shareholders. Illinois amended its constitution to prohibit ad valorem taxation of personal property held by individuals. While the amendment was being challenged, Hillsboro continued to pay the taxes and claim the deductions. Eventually, the amendment was upheld and the state refunded the taxes directly to Hillsboro's shareholders. Hillsboro did not report any income from the refund, and the IRS determined a deficiency. In a consolidated case, Bliss Dairy was a closely held corporation that kept its books on a cash basis. Bliss deducted the price of cattle feed purchased during the operating year, under section 162, whether or not the feed was actually consumed; much of the feed remained at the end of the year. Two days into the new tax year, Bliss liquidated and distributed its assets, including cattle feed, to its shareholders. Section 336 allowed the tax-free distribution of assets in liquidation; Bliss reported no income from the distribution. The shareholders deducted the basis of the feed as an operating expense in the year received. The tax benefit rule requires the inclusion of income when events occur that are fundamentally inconsistent with an earlier deduction. Hillsboro and Bliss asserted that while the tax benefit rule requires the recognition of recoveries, no recovery occurred in either case. The IRS argued that the tax benefit rule requires recognition when previous deductions become inconsistent because of later events, whether or not there was a physical recovery by the corporation. The IRS determined deficiencies against both Hillsboro and Bliss. In an opinion written by Justice O'Connor, the Supreme Court held that the tax benefit rule required Bliss to recognize income but did not require Hillsboro to do so. The Court explained the purpose of the tax benefit rule as approximating a transactional accounting system, so as to eliminate some of the distortions created by an annual tax system. Application of the tax benefit rule does not require actual physical recovery, the Court stated, but does require examination of the specific Code sections and of the particular facts at issue. In the Hillsboro case, the Court reasoned, the events were not inconsistent with the goals of section 164, which allowed banks to deduct dividends by receiving a deduction for taxes paid on behalf of shareholders. The Supreme Court determined that the intent of Congress in allowing the section 164 deduction was to grant relief to corporations making the payments for their shareholders; Congress was not concerned with the ultimate use of the funds by the state. The Court cautioned that the tax benefit rule would only apply if the original payment was negated by a refund to the corporation. The Supreme Court stated that the distribution of the feed to shareholders was inconsistent with Bliss's earlier deduction. The Court explained that section 162 allows for the deduction of ordinary and necessary business expenses, but is premised on the consumption of the expensed goods. Disposing of or consuming an asset after it has been expensed, the Court noted, would be inconsistent with the earlier deduction. While section 336 allows the nonrecognition of assets distributed in liquidation, it does not eliminate all recognition. The Court reasoned, therefore, that Bliss was required to recognize the amount previously claimed as a deduction. Justice Stevens concurred with the Hillsboro opinion and dissented with the Bliss opinion, believing the taxpayers should have received equal treatment. He argued that neither corporate taxpayer recovered any part of its expenditure, and, thus, the tax benefit rule did not apply to either of them. In dissent, Justice Blackmun argued that, in both cases, the deductions were negated when the premises upon which they were based were destroyed. According to Justice Blackmun, neither of the taxpayers should have been allowed to retain the tax benefit of a subsequently inappropriate deduction, and both should have been required to amend their returns for the years at issue, rather than add income to subsequent returns. Justice Brennan dissented regarding Hillsboro, agreeing with Justice Blackmun that the majority improperly applied the tax benefit rule, because, ultimately, there was no tax on the bank's stock.

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BANK NOT REQUIRED BY TAX BENEFIT RULE TO RECOGNIZE INCOME FROM REFUNDS PAID TO SHAREHOLDERS.