Firm Takes Aim at Deadwood Regs

May 10, 2018

CC:PA:LPD:PR (REG-132197-17)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue, NW
Washington DC 20044

Comment on Notice of Proposed Rulemaking REG-132197-17 (Eliminating Unnecessary Tax Regulations)

Dear Sir/Madam:

We are submitting this comment in response to Notice of Proposed Rulemaking REG-132197-17 (the “Notice”), which proposes to eliminate certain unnecessary Internal Revenue Service (“IRS”) regulations.

In addition to the regulations identified for elimination in the Notice, we are proposing the elimination of Treasury Regulation § 1.111-1 (“Treas. Reg. § 1.111-1”). The elimination of Treas. Reg. § 1.111-1 is appropriate, because it is obsolete. Treas. Reg. § 1.111-1 has not been amended to reflect significant statutory amendments enacted in 1984, and for several decades before those amendments were enacted, the regulation had not been amended to accurately reflect the state of the law.

In its current form, Treas. Reg. § 1.111-1 does not provide the public with useful guidance and, in fact, is misleading, because it suggests limitations on a judicially-developed doctrine that have not been approved by either Congress or the courts.

The Tax Benefit “Exclusionary Rule”

The tax benefit rule, partially codified at IRC § 111, began as a judicially-developed rule intended to alleviate the inequities created by the annual accounting system adopted for computing the federal income tax.¹ Initially, the tax benefit rule was only “inclusionary,” meaning that it operated to require a taxpayer that took a deduction in one year and then recovered the deducted amount in a subsequent year to include the recovered amount in income in the subsequent year.² The rule was intended to put a taxpayer in the same position that it would have been had the event causing the deduction and the event causing the recovery occurred in the same tax year.³

However, the inclusionary aspect of the tax benefit rule, as developed by the courts, did not entirely eliminate the inequities created by the annual accounting system because if a taxpayer realized no tax benefit from the deduction, then including the later-year recovery amount in income would put the taxpayer in a worse position than it would have been had both events occurred in the same tax year. As a result, courts have acknowledged that a limitation on the inclusionary rule was necessary.⁴ That limitation became known as the “exclusionary rule”.

Partial Codification of the “Exclusionary Rule” and the Promulgation of Regulation § 29.22(b)(12)-1

In 1942, the Treasury Department (“Treasury”) urged Congress to codify the exclusionary rule “to eliminate as far as possible existing inequities [caused by the inclusionary rule] which distort the tax burden of certain taxpayers.”⁵ Specifically, Treasury suggested that Congress codify this rule with respect to recoveries of bad debts and taxes previously deducted:

If a taxpayer who has taken a bad debt deduction later receives payment of such debt, such payment must be included in his income even though he obtained no tax benefit from the deduction in the prior year. While this result is theoretically proper under our annual system of taxation, it may produce severe hardships in certain cases through a distortion of the taxpayer's real income It is believed that the hardships can be removed . . . by excluding from income amounts received in payment of the debt to the extent the deduction on account of the debt in the prior year did not produce a tax benefit. . . . It is also urged that this treatment be extended to refunds of taxes previously deducted.⁶

Congress followed Treasury's advice and partially codified the exclusionary rule in 1942 as Section 22(b)(12) of the Internal Revenue Code of 1939.⁷ As enacted, the statutory exclusionary rule was limited in its application to only three specific types of recoveries: (1) recovery of bad debts; (2) recovery of previously deducted taxes; and (3) recovery of previously deducted delinquency amounts.⁸

Under Section 22(b)(12), taxpayers could exclude “income attributable to the recovery during the taxable year of a bad debt, prior tax, or delinquency amount, to the extent of the amount of the recovery exclusion with respect to such debt, tax, or amount.”⁹ The term “recovery exclusion” was defined as the “amount . . . of the deductions or credits allowed, on account of such bad debt, prior tax, or delinquency amount, which did not result in a reduction of the taxpayer's tax.”¹⁰ Congress assigned to the IRS and Treasury the task of defining how to compute the amount of a “recovery exclusion.”¹¹

Accordingly, the following year, in 1943, Treasury promulgated Regulation § 29.22(b)(12)-1 entitled “Recovery of bad debts, prior taxes and delinquency amounts.”¹² The regulation accomplished the assigned task of defining the term “recovery exclusion” and providing rules for computing such an exclusion. Importantly, however, just as Section 22(b)(12) of the Internal Revenue Code of 1939 applied only to recoveries of bad debts, previously deducted taxes and previously deducted delinquency amounts, Regulation § 29.22(b)(12)-1 was also limited in its application to recoveries of those three items.¹³

Dobson v. Commissioner and the Amendment of Regulation § 29.22(b)(12)-1

In 1943, after the promulgation of Regulation § 29.22(b)(12)-1, the United States Supreme Court decided Dobson v. Commissioner.¹⁴ This decision ultimately prompted Treasury to make changes to the regulation.

The particular facts of Dobson are not as important as the Court's general discussion of the exclusionary rule and the Court's broad holding. In Dobson, the government argued that the exclusionary rule could only apply to recoveries of the specific items — like recoveries of previously deducted bad debt — that Congress had addressed in Section 22(b)(12) of the Internal Revenue Code of 1939.¹⁵ The Court disagreed, explaining that congressional action is not necessary for the exclusionary rule to apply. According to the Court, the only reason Congress acted with respect to recoveries of previously deducted bad debts was because the courts had issued decisions involving such recoveries in which the exclusionary rule had not been applied, despite the fact that the deduction of the bad debts had failed to produce a tax benefit.¹⁶ The Court allowed the application of the exclusionary rule in Dobson even though the particular recovery at issue did not involve one of the three items specifically enumerated in Section 22(b)(12). The Court further noted, in dicta, that the exclusionary rule could apply to a variety of recoveries beyond those specified in Section 22(b)(12):

It arises not only in case of recoveries of previously charged off bad debts and recoveries of the type we have here. It is also present in the case of refund of taxes or cancellation of expenses or interest previously reported as accrued, adjustments of depreciation and depletion or amortization, and other similar situations.¹⁷

Ultimately, the Dobson Court announced the broad holding that “no statute or regulation . . . and no principle of law compels the Tax Court to find taxable income in a transaction where as a matter of fact it found no economic gain and no use of the transaction to gain tax benefit.”¹⁸ According to the Court, if application of the exclusionary rule is needed to avoid the inclusionary rule's harsh result of taxing recovery of a deduction that produced no tax benefit, then neither Congress nor the IRS can restrict that.

Less than two years later, in 1945, Treasury amended Regulation § 29.22(b)(12)-1 and included a specific reference to the Dobson case.¹⁹ Treasury changed the title of the regulation from “Recovery of bad debts, prior taxes and delinquency amounts” to “Recovery of certain items previously deducted.” The change in the title alone signals an expansion of the scope of the regulation beyond the three specific items addressed by Code Section 22(b)(12). Treasury also amended the text of the regulation to expand the scope beyond the three items in Code Section 22(b)(12), but at the same time Treasury added language limiting that expansion so it did not cover “depreciation, depletion, amortization, or amortizable bond premiums”:

The rule of exclusion so prescribed by statute applies equally with respect to all other losses, expenditures, and accruals made the basis of deductions from gross income for prior taxable years . . . but not including depreciation, depletion, amortization, and amortizable bond premiums. See Dobson v. Commissioner, 64 S. Ct. 239.²⁰

The most recent change to the regulation came in 1956. When Congress overhauled the Internal Revenue Code in 1954, Section 22(b)(12) became Section 111 of the Internal Revenue Code of 1954.²¹ In 1956, Treasury updated the numbering of its regulations to correspond to the sections in the new 1954 Code. As a consequence, Regulation § 29.22(b)(12) became Treas. Reg. § 1.111-1.²² At the same time, Treasury removed the reference in the regulation to the Dobson case. However, no change was made to the assertion in the regulation, inconsistent with the dicta in Dobson, that the exclusionary rule did not apply to depreciation, depletion, and amortization.²³

The Deficit Reduction Act of 1984 (P.L. 98-369) Substantially Revises IRC § 111(a)

IRC § 111 (a) remained substantially unchanged until 1984, when Congress amended IRC § 111. Congress changed the title of IRC § 111 from “Recovery of Bad Debts, Prior Taxes, and Delinquency Amounts” to “Recovery of Tax Benefit Items.” Similar to the 1945 regulatory change, the change in the title of IRC § 111 signaled an expansion of the statutory tax benefit rule beyond the three specific items previously addressed by the statute. Furthermore, instead of addressing only recoveries of those three specific items, the new version of IRC § 111(a) was broadly worded to cover any recoveries:

Gross income does not include amounts attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.²⁴

This is what IRC § 111(a) still says today. The statute applies to “the recovery . . . of any amount deducted in any prior taxable year” to the extent the deduction didn't produce a tax benefit.²⁵ There is no limitation on the types of deductions covered by the statute, and this is consistent with how the Supreme Court viewed the scope of the exclusionary rule.²⁶

No change was made to Treas. Reg. § 1.111-1 to reflect the 1984 amendment to IRC § 111. The text of the regulation remains unchanged since it was last updated in 1956. Thus, Treas. Reg. § 1.111-1 continues to include the limiting language added in 1945 purporting to remove recoveries of depreciation, depletion, and amortization from the scope of the exclusionary rule. Even in 1945, this limitation exceeded Treasury's rule making authority in light of the dicta in Dobson.

However, even if the limiting language in Treas. Reg. § 1.111-1 was authorized when it was first promulgated over 70 years ago, it has since become obsolete and meaningless as a result of the 1984 amendment to the Internal Revenue Code. That amendment explicitly removed the “recovery exclusion” language along with the reference to the Treasury Regulations.²⁷ As noted above, IRC § 111 was amended to express the tax benefit rule as a broad but simple principle. Because the “recovery exclusion” concept was removed from IRC § 111 by the 1984 legislation, Treas. Reg. § 1.111-1, which is built around that concept, and imposes limitations on the exclusionary rule that have no support in the current version of IRC § 111, is obsolete.

The continued existence of Treas. Reg. § 1.111-1 in this obsolete form provides no meaningful guidance to taxpayers that cannot be obtained from a review of the current statutory language, and creates a risk of confusion, by suggesting limits to the exclusionary rule that are not supported by either the case law or the current version of IRC § 111.

Please contact me if the Department needs any additional information in support of this comment Sincerely,

Michael A. Jacobs
Reed Smith
Philadelphia, PA

cc:
Kyle O. Sollie, Esq.