Extent to Which Payments for Losses Will Reduce Amount Deductible Under Section 165

(2) Whether * * * payments to be contributed by * * * to * * * the taxpayers, for business reasons will constitute a nonshareholder contribution to capital under I.R.C. section 118?

(3) Will payments voluntarily contributed by * * * to * * * the taxpayers, * * * reduce the amount of the loss otherwise deductible by the taxpayers under section 165?

For purposes of analyzing issues two and three we will assume that the taxpayers should be treated as having received and disbursed the payments.

(2) We conclude that the * * * payments that will be contributed * * * through a * * * to * * * the taxpayers, do not constitute nonshareholder contributions to capital under section 118. Our conclusion is based on * * * G.C.M. 37354, I-155-77 (Dec. 21, 1977), which concluded that when contributors are motivated by the desire to obtain benefits that have a reasonable nexus to their business, as in this case, then the payments made do not constitute nonshareholder contributions to capital. We believe that the exclusion for nonshareholder contributions to capital is restricted to instances where the contributor will enjoy the benefits only through its capacity as a member of the general community.

(3) This Division has previously considered what type of payments constitute compensation "by insurance or otherwise" which reduces the amount of the otherwise available section 165 loss deduction. In * * *, G.C.M. 34380 I-3683 (Nov. 20, 1970), Tax Treatment of Debt Cancellations Under the Disaster Relief Acts of 1969 and 1970, G.C.M. 34433, I-4031 (Feb. 12, 1971), published as Rev. Rul. 71-160, 1971-1 C.B. 75, and * * *, G.C.M. 38032 I-6-79 (Aug. 1, 1979), we concluded that compensation "by insurance or otherwise" under section 165 is limited to legal claims of right. Under the view expressed in those G.C.M.s, the voluntary payments to be made by * * * to * * * that suffered the casualty loss will not be considered compensation under section 165.

We disagree with the view that only legal claims of right constitute compensation and believe that payments received from * * * will reduce the amount otherwise available as a loss deduction under section 165. Our conclusion is based on the view that the purpose of the offset for compensation is to ensure that before a taxpayer may take a deduction for a loss under section 165, a taxpayer must in fact have realized one, that is, it must not have been reimbursed for the loss. Since the payments received from * * * will be used, * * * the payments should offset the loss. Furthermore, since at all times * * * have had a reasonable prospect of recovery * * *, no deduction under section 165 has yet been proper.

G.C.M.s 34380, 34433, and 38032 are hereby modified to the extent that they indicate that only legal claims of right constitute compensation "by insurance or otherwise" under section 165.

* * * Pursuant to an agreement * * * was engaged by the Operating Companies to manage, on their behalf and as their agent, * * * is also owned by * * * and is therefore * * * the Operating Companies. It is likely that * * * rather than the Operating Companies themselves, will be the entity which will receive the payments * * * and which will disburse the funds so received * * * The operating agreement between the Operating Companies * * * provides that the costs incurred * * * shall become the liabilities of the Operating Companies. The agreement also provides that the services rendered * * * will be at actual cost.

The Supreme Court, in National Carbide Corp. v. Commissioner, 336 U.S. 422 (1949), stated that, in the absence of a sham transaction, a corporate entity will not be disregarded unless a true agency exists. It set forth the standards by which the relationship between a corporation and its shareholders is to be judged in determining whether there is a principal-agent relationship. The Court stated that for a true agency to exist the agent's relationship with the principal must not be dependent upon the fact that it is owned by the principal and its business purpose must be the carrying on of the normal duties of an agent. The Court also set forth four other factors as some of the relevant considerations of whether a true agency exists: the corporation 1) operates in the name of and for the principal, 2) binds the principal by its action, 3) transmits money received to the principal and 4) receives income attributable either to the services of the principal's employees or to assets belonging to the principal. Accord, Roccaforte v. Commissioner, 52 AFTR2d 83-5332 (5th Cir. 1983).

In this case, * * * is not owned by the Operating Companies that seek to be regarded as its principal, so that presumably the mandatory first requirement for an agency relationship established in National Carbide, as applied in this case, is that the relationship between * * * and the Operating Companies would not be dependent upon their * * *. The fact that under the Operating Agreement * * * will make no profit on its activities might defeat this requirement, although the fact that * * * is fully compensated for all its expenses is in accordance with this requirement. See Roccaforte v. Commissioner. Regarding the other requirements, there does not seem to be sufficient information to determine whether they are satisfied.

Aside from the fact that the Service should be reluctant to, in essence, disregard the separate existence of a corporation for tax purposes, it may be difficult to issue a ruling on the existence of an agency relationship due to the factual nature of the determination. In addition, a determination whether the amounts received * * * should be regarded as received by the Operating Companies and disbursed by them * * * would depend only on whether the Operating Companies are viewed as having the right to these payments, which right they have assigned * * *. Accordingly, resolution of the agency issue may be unnecessary. We recommend that you discuss the purpose and scope of the ruling request with the taxpayers and obtain any additional factual information you determine is necessary. At that time, we will be happy to provide assistance in resolving any legal issues that you believe remain.

For purposes of analyzing issues two and three we will assume that the Operating Companies are treated as having received the payments * * * and disbursed the payments.

Section 118(a) states that in the case of a corporation, gross income does not include any contribution to the capital of a corporation.

* * *

The legislative history of section 118(a) indicates that it was intended to be a codification of existing law that had developed through court decisions:

Treas. Reg. section 1.118-1 does not define the term "contribution to capital" but provides only a few examples dealing with nonshareholder contributions to capital:

G.C.M. 37354 states that the motive which the transferor must have in order for the payment to qualify as a contribution to capital cannot be precisely defined in universal terms and each case must be decided on its own facts. The memorandum sets forth the following guidelines describing factual patterns where the motive is or is not present:

GCM 37354 also concluded that when a contributor has a dual motivation, that is, a transfer is made both for business reasons and for community or public benefit, the transfer cannot be considered a contribution to capital. GCM 37354 at pages 30-31. If the transferor does not have the requisite motivation, or has a prohibited motivation, then the transfer cannot be a nonshareholder contribution to capital and the transfer need not be examined from the recipient corporation's point of view. GCM 37354 at pages 25-26.

We recognize that our analysis of the law concerning nonshareholder contributions to capital is inconsistent with cases that have considered the application of section 118 to department stores that receive a subsidy from a developer as an inducement to locate in a particular shopping center. In Federated Department Stores, Inc. v. Commissioner, 51 T.C. 500 (1968), aff'd, 426 F.2d 417 (6th Cir. 1970), nonacq., 1971-2 C.B. 4., A.O.D. June 29, 1970, a developer owned a large tract of unimproved land upon which it planned to develop residential units and a shopping center. The developer believed that one of the taxpayer's stores could serve as an anchor store in the shopping center, attracting customers and better tenants, and thereby increase the developer's rental income from its percentage-of-sales leases. To induce the taxpayer to establish a store in the shopping center, the developer agreed to convey a ten-acre tract of land and to pay $200,000 annually for a ten year period. The Service argued in the Tax Court that, because the payments were made purely for business reasons in order to increase the value of the shopping center land and rentals, the payments were in consideration for goods or services to be rendered and that section 118 was inapplicable. The Tax Court did not dispute the relevance of the transferor's motivation but held that, when a transferor anticipates only an indirect benefit, then the payment will constitute a contribution to capital.

Before the Sixth Circuit the Service argued that the payments were gross income to the taxpayer since they were motivated by financial self-interest rather than general community welfare. The Sixth Circuit affirmed the Tax Court and held that the contributions of money and land constituted a tax free contribution to capital, regardless of the financial motive or intent of the developer, because it found the expectations of profits to be so intangible and speculative that any benefit would have to be regarded as indirect. The Court held that absent a "reasonable nexus" between the contribution and the services provided by its recipient as part of its business, the contribution could not be regarded as a payment for future goods and services.

The A.O.D. on Federated Department Stores, June 29, 1970, recommended that a petition for certiorari not be filed on the ground that the decision did not conflict with any other appellate court opinion. The A.O.D. stated that the Service continues to believe that the payments by the developer in that case did not come under section 118 because the developer made the payments only in anticipation of the financial benefits to itself and because the developer is the direct and immediate beneficiary of these payments, while the community at large will benefit only incidentally and indirectly.

In May Department Store Co. v. Commissioner, 1974-253 T.C.M. 1128 (1974), aff'd per curiam, 519 F.2d 1154 (8th Cir. 1975), land was conveyed to the taxpayer by a developer of a shopping center in return for the taxpayer agreeing to locate and maintain a retail store on the site conveyed. The court indicated that whether section 118 applied depended on whether the benefits the developer expected to derive from the transaction were the kind of indirect and intangible benefits which the legislative history indicates would prompt a nonshareholder contribution to capital, relying on Federated Department Stores. The Service argued that benefits which are indirect and intangible are those benefits which the contributor can enjoy only as a member of the community at large. The court stated that the Service definition of indirect and intangible benefits was unduly restrictive and found that the benefits sought by the developer were indirect and intangible. Accordingly, the court held that the conveyance was a contribution to capital under section 118.

The A.O.D. in May Department Stores, October 25, 1974, recommended that the Service nonacquiesce in the Tax Court opinion and appeal the case. The A.O.D. reiterated the view argued in the Tax Court that the conveyances did not come within section 118 because they resulted in direct and tangible benefit to the developer and would benefit the community at large only incidentally and indirectly. This view is consistent with the view expressed in GCM 37354 that when a transfer is made for both business reasons and for the benefit of the community, the transfer cannot be considered a contribution to capital. GCM 37354 at pages 30-31. We note that it is highly questionable whether the taxpayer involved in May Department Stores did, in fact, have any motivation other than a business motivation.

We believe that the Service's position that Federated Department Stores and May Department Stores were incorrectly decided is correct. The narrow business benefits were not sought by the contributors as members of the community in general. In those cases there was a reasonable nexus between the contributions and business benefits to the contributor and, therefore, the contributions should not qualify under section 118.

We note the presence of a Tax Court case where narrow business motivation led the court to hold that the payment in question was not a nonshareholder contribution to capital. In John B. White, Inc. v. Commissioner, 55 T.C. 729 (1971), aff'd per curiam, 458 F.2d 989 (3d Cir. 1972), the court held that a corporation operating a Ford car dealership received taxable income when the corporation received payment from the Ford Motor Co. to locate in a more desirable neighborhood. The court found that Ford expected to benefit from the relocation through increased sales of its products and enhancement of its image. The court characterized the line between that case and Federated Department Stores as shadowy. It distinguished that case on the ground that Ford's payments clearly had a reasonable nexus with the services the dealer had provided and that the anticipated benefits were neither indirect nor intangible but were the very benefits which Ford relied upon in establishing authorized dealerships.

* * *

Another major business benefit sought * * * a * * *. This motivation also prevents exclusion of the payments under section 118. Applying the factual guidelines outlined in GCM 37354, the payments are being made to achieve business purposes * * * and there is a reasonable nexus between the payments and the business * * *. This benefit may be considered a direct benefit of the sort which would disqualify a payment from section 118 treatment because it is enjoyed only * * *. The benefit may be considered to be tangible because * * *. The payments are made to serve only the narrow business purposes of * * * and are not made for the purposes of obtaining an advantage for the general community. The narrow business purpose is evident from the fact * * *. The payments benefit the community at large in the sense that * * *. These benefits to the community are truly incidental. We believe the Service should take the position that a contribution will satisfy the contributor motivation test under section 118 when the benefits sought are indirect in the sense that they may only be enjoyed by the contributor in his capacity as a member of the community. Such a test is not satisfied when, as in this case, there is a reasonable nexus between the payment and business purposes of the taxpayer.

The payments made * * * to the Operating Companies will be used to * * * that clearly represent a loss to the Operating Companies within the meaning of section 165. The amount of the loss deductible under section 165 is the lesser of either the diminution in fair market value * * * or the amount of the adjusted basis of the single, identifiable property * * *. Treas. Reg. section 1.165-7(b)(1) and (2). The estimated cost of * * * contributes to a loss in the fair market value of the property and therefore such costs may be used as evidence of the amount of the loss sustained if the conditions of Treas. Reg. section 1.165-7(a) (2)(ii), relating to using repair costs as evidence, are met. See Rev. Rul. 71-161, 1971-1 C.B. 77, considered in Tax Treatment of Debris Removal Cost Reimbursements Under the Disaster Relief Act of 1969, GCM 34438, I-4085 (Feb. 22, 1971), which concludes that the cost of debris removal may be used as evidence of the amount of a casualty loss.

Treas. Reg. section 1.165-7(a)(2)(ii) provides that repair costs may be used as evidence of the loss in value if the taxpayer shows that

Unless otherwise excluded, the payments made * * * in this case clearly would be includible in the gross income of the Operating Companies. Section 61. The payments are not excludable as a gift because they are being made in order to benefit the * * * and not out of detached and disinterested generosity. Commissioner v. Duberstein, 363 U.S. 278 (1960).

In determining whether the payments * * * represent compensation "by insurance or otherwise" which would reduce the loss available under section 165 and, therefore, be excluded from income, under the principle of statutory construction, ejusdem generis, the "or otherwise" language of section 165 should be read as requiring that the compensation be similar in nature to insurance. Shanahan v. Commissioner, 63 T.C. 21, 23 (1974). Application of this principle raises the question of what characteristics of insurance must be present in order for a payment to be considered similar for purposes of this section.

This Division has considered the meaning of the words "compensated for by insurance or otherwise" contained in section 165 in other cases. In GCM 34380, supra, we concluded that the principle of ejusdem generis indicates that compensation within the meaning of section 165(a) is to be limited to legal claims of right such as insurance. The GCM further concluded that excludible gifts do not constitute compensation within the meaning of section 165(a) and do not reduce the amount of the deduction allowed under that section, regardless of whether they are required to be used or are actually used to repair or replace the property which is the subject of the casualty loss deduction claim. The GCM recommended modification of two revenue rulings that concluded that gift payments to a disaster victim constitute compensation under section 165 to the extent the payments must be used by the recipient to rehabilitate or replace the property that is the subject of the claimed loss deduction. These revenue rulings, Rev. Ruls. 53-131, 1953-2 C.B. 112, and 64-329, 1964-2 C.B. 58, have not yet been modified in accordance with the recommendation of the GCM.

In GCM 34433, supra, we held that cancellation under federal disaster relief legislation of indebtedness to the government owed by a disaster victim constituted compensation under section 165. GCM 34433 was published as Rev. Rul. 71-160, supra, and the conclusion was adopted in Shanahan v. Commissioner, supra. The GCM concluded that compensation within the meaning of section 165 is limited to legal claims of right such as insurance. The GCM stated that the debt cancellation under disaster relief legislation is a legal claim of right because a victim has a legally enforceable right to the recovery. It distinguished GCM 34380 on the ground that the gifts held not to be compensation in that case were not made pursuant to a legal claim of right.

This Division has also considered the meaning of the words "or otherwise" in a case similar to that presented here. GCM 38032, supra, involved a non-profit corporation created by a * * *, for the sole purpose of receiving voluntary payments from members of * * * and distributing the proceeds * * * and were made because the association determined that giving such aid would benefit its members. The GCM concluded that the payments were income to the recipients because they were not made out of disinterested generosity. The GCM also concluded that the payments did not reduce the section 165 loss * * * the ground that compensation under section 165 is limited to payments made pursuant to legal claims of right, such as insurance. The GCM also reaffirmed the conclusion of GCM 34380 that Rev. Ruls. 53-131 and 64-329 concerning gifts should be modified. The situation involved in GCM 38032 is closely analogous to the situation considered here because the payments made by * * * like the payments to be made * * * to the Operating Companies, are made for self-interested business reasons, and not pursuant to a legal claim of right.

Under the rationale of GCMs 34380, 34433, and 38032, that compensation "by insurance or otherwise" under section 165(a) is limited to legal claims of right, the payments from * * * which will not be made pursuant to any legal obligation, will not constitute compensation under the section. We disagree with the view that only payments made pursuant to legal claims of right constitute compensation and believe that the payments made * * * will be compensation "by insurance or otherwise." Our conclusion is based on the fact that the purpose of the offset for compensation is to ensure that before a taxpayer may take a deduction for a loss under section 165 he must in fact have realized one, that is, he must not have been reimbursed for the loss. J. Mertens, Law of Federal Income Taxation section 28.07 (1980 rev.). The payments made * * * will be made solely * * * and will be used to * * * it. The payments by * * * are also similar to insurance in that they have the effect of spreading the loss * * * among similarly situated parties, the other members of * * *. Therefore, these payments should offset the loss.

Our position is supported by a Tax Court decision involving a closely analogous situation where a payment not made pursuant to a legal claim of right was held to constitute compensation under section 2054./3/ Estate of Bryan v. Commissioner, 74 T.C. 725 (1980), involved a loss which resulted when an attorney embezzled funds from the decedent's estate. As a result of the loss, the estate received money from a fund, supported by annual contributions of attorneys, which reimburses victims of the improper conduct of attorneys. The fund was created under state law and administration of it is governed under the state rules of procedure. The trustees of the fund reimburse victims to the extent they deem proper and reasonable. The case considered whether the payment from the fund constituted compensation "by insurance or otherwise" which would reduce the amount of the theft loss deductible from the gross estate under section 2054 due to the embezzlement, and stated that similarly worded section 165 was applicable by analogy.

The court cited the principle ejusdem generis and stated that the words "or otherwise" must be construed consistently with the specific term "insurance." The court also stated that the type of compensation received must be such that it was structured to replace what was lost. The court held that the payment could be considered in the nature of insurance for federal tax purposes even though not considered an insurance payment under state laws and that the absence of a legal or moral obligation to make a payment does not prevent characterization of the payment as in the nature of insurance. The court concluded that the payment was in the nature of insurance even though it spread the risk of loss among those who caused the loss rather than those who suffer the loss directly. The court said it spread the risk of loss of the good name of the bar among those who have an interest in maintaining it.

In reaching our conclusion we also disagree with the view expressed in GCM 38032 at page nine and in GCM 34433 at page two that the fact that payments under federal disaster relief legislation constitute compensation supports the general proposition that a payment must be made pursuant to a legal claim of right in order to constitute "compensation" under section 165. Government assistance payments are made pursuant to a legal obligation only in the sense that, after a relief program is enacted, one has a legal right to recover under the terms of the law. However, unlike a tortfeasor which is legally bound to pay for damages or an insurance company which is legally bound to honor an insurance contract, a government is not bound to establish programs which aid disaster victims. In our view, the disaster relief payments are considered compensation under section 165 primarily because they reduce the amount of loss suffered and also because they are similar to insurance in that they spread the cost of a disaster.

Our view of payments made pursuant to disaster relief legislation is supported by Shanahan v. Commissioner, supra. The court in that case held that a disaster victim received compensation under section 165(a) when, pursuant to federal disaster relief legislation, a portion of a loan the victim received from the government was cancelled. It noted the fact that the federal government was not obliged to compensate the victim for the property loss. Nevertheless, the court found that the payment to the victim was in the nature of insurance because, through the disaster relief legislation, Congress provided a limited but uniform means of spreading the risk of disaster losses throughout the population of the United States. In addition, the court relied on the fact that the loan cancellation provision was exercisable to the extent the loss was not compensated for by insurance or otherwise, which is also true with respect to * * * payments. The court also noted that section 165 is designed to provide relief for losses actually suffered and that therefore a taxpayer must net any compensation received to determine the actual loss suffered. Although the court noted that the taxpayers had a right to have a portion of their loan cancelled under the statute in question, it did not appear to find this factor determinative. Smith v. Commissioner, 76 T.C. 459 (1981), acq. on another point, 1981-2 C.B. 2 (A.O.D. 1066), and Spak v. Commissioner, 76 T.C. 464 (1981), both involving payments by the federal government as a result of flood damage, rely on Estate of Bryan and Shanahan and are consistent with our interpretations of these cases.

We are aware that a Court of Claims case, Forward Communication Corp. v. U.S., 608 F.2d 485, 501 (Ct. Cl. 1979), stated that "[t]he bar in section 165(a) against a loss deduction . . . . applies only if the taxpayer has an existing legal right of recovery from some source." We believe the case is distinguishable on its facts because the court dealt with the issue of whether there was a nexus between the loss claimed by a television station (abandoning one network affiliation) and another event (getting an exclusive affiliation with another network). The holding of the case, that gaining the exclusive affiliation with another network was not compensation, could have been reached on the narrower ground that there was simply not an adequate connection between the two events for purposes of section 165. See George Freitas Dairy, Inc. v. United States, 582 F.2d 500 (9th Cir. 1978).

GCM 34380 is hereby modified to the extent that it states that only legal claims of right constitute compensation under section 165. We have not reconsidered its conclusion that gifts should not be regarded as compensation. However, we recognize that treating gifts, which are excludible from gross income under section 102, as "compensation" for purposes of section 165 would, in effect, mean that such payments were taxable, and this result appears inconsistent with the legislative policy not to tax such payments. We further note that certain government disaster relief payments, which are excludible from gross income under the general welfare exception and have been held to constitute compensation under section 165, are arguably distinguishable from gifts because the compensatory nature of the payments makes them in the nature of insurance. See Rev. Rul. 76-144, 1976-1 C.B. 177, and Rev. Rul. 75-28, 1975-1 C.B. 68.

GCM 34433 is hereby modified to the extent that it indicates that only legal claims of right constitute compensation under section 165. GCM 38032 is hereby modified on the issue of whether payments involved in that case constituted compensation under section 165. In our view the payments involved in that case do constitute compensation.

Because we have concluded that the payments by * * * constitute compensation "by insurance or otherwise," a question arises as to the effect the possibility of receiving these payments has on the Operating Companies' sections 165(a) loss. Under Treas. Reg. section 1.165-1(d), a section 165 loss is sustained and therefore deductible in the year of loss unless there exists in that year a claim for reimbursement with respect to which there is a reasonable prospect of recovery. The regulation further provides that whether a reasonable prospect of recovery exists with respect to a claim for reimbursement of a loss is to be determined upon an examination of all facts and circumstances. Thus, although we have concluded that there need not be a legal claim of right, there must be a reasonable expectation of reimbursement for the loss in the year of the loss in order to defer the deduction./4/ The issue here is not whether the taxpayer had a reasonable prospect of recovering * * * payments * * * but rather whether the taxpayer had a reasonable prospect of recovery from any source.

The Operating Companies have not yet deducted any part of the losses * * *. We believe the decision to defer the deduction is proper on the ground that at all times * * * there has existed a reasonable prospect of recovery * * *. The suits filed against * * * certainly created a reasonable prospect of recovery of at least a portion of * * *. Although the suit against * * * there has continued to exist a reasonable prospect of recovery because the Operating Companies have * * *.

In normal circumstances * * * might not represent a reasonable prospect for recovery. In this case, however, * * *.

Finally, the taxpayer also requested a ruling that to the extent that any portion of the payments which the Operating Companies receive * * * during any taxable year represents reimbursement for expenditures for which the Operating Companies claimed a deduction in a prior year's tax return, such portion of the * * * payments shall be includible in the Operating Companies' gross income, subject to the provisions of section 111. That ruling should be granted because it is clearly supported by Treas. Reg. section 1.165-(1)(d)(2)(iii).

² It should be noted that since the * * * are treated in this situation for purposes of section 165 as a measure * * * made by the Operating Companies should be treated as made for replacement of part of the property and capitalized and added to the basis of the property. Section 1016(a)(1); Rev. Rul. 71-161, 1971-1 C.B. 76.

³ Section 2054 provides a deduction for "losses incurred during the settlement of estates . . . when such losses are not compensated for by insurance or otherwise."

⁴ Similarly, a taxpayer is not allowed a deduction under section 162 for an expense for which there is either a right or a reasonable expectation of reimbursement, Federal Disaster Assistance Administration, GCM 37920, I-351-77 (April 5, 1979), 1, 11-12, published as Rev. Rul. 79-363, 1979-2 C.B. 82.