The Taxable Year

AuthorDeborah A. Geier
Pages653-706
-653-
Chapter 20: The Taxable Year
As a theoretical matter, Congress could delay the payment of income tax until the end of a
taxpayer’s life and the determination of the taxpayer’s aggregate realized income (or loss) over his
entire lifetime. As such an approach would be impractical, however, Congress requires that tax be
figured and paid after the end of each “taxable year,” defined in § 441 as either the calendar year
or a fiscal year, with the latter further defined in § 441(e) as a 12-month period “ending on the last
day of any month other than December.” A taxable year is usually determined by the way in which
the taxpayer keeps his books and records and is effectively adopted by the filing of the first tax
return using a particular taxable year.1 Thereafter, a taxpayer generally must obtain permission to
change its taxable year under § 443 in order that income does not slip through the cracks in the
change year. The taxable year of most individuals is the calendar year. Some taxpayers,
particularly corporations, may use a fiscal year to better conform to, say, a seasonal business.
While clearly necessary as an administrative matter, artificially segmenting our lives into yearly
periods creates some tensions regarding how events and expectations in one year should (or should
not) affect tax consequences in another. This chapter first reviews the “annual accounting
principle” and topics that we have considered throughout this textbook that implicate it. Two
additional facets of the annual accounting principle that we have not yet discus sed is the tax benefit
rule, considered in Part B., and the net operating loss deduction, explored in Part C.
A. The annual accounting principle in general
The “annual accounting principle” was first introduced in Chapter 1 and has been revisited
many times since then. In general, the annual accounting principle requires that Gross Income
(wealth accessions) and deductions (wealth reductions) be determined based upon facts (and
expectations) known as of each current year. The most significant deviation from the annual
accounting principle is the realization requirement, under which wealth increases and decreases in
the form of changes in property value are ignored until a realization event, such as a sale or
exchange of the property. But we have considered other aspects of the annual accounting principle,
as well, several of which are briefly reviewed below.
The borrowing exclusion
The borrowing exclusion (studied in Chapter 9) is another significant deviation from the annual
accounting principle in that cash in hand that is not basis recovery is nevertheless permitted to be
excluded from the tax base solely because of what we believe will happen in a future year:
repayment with after-tax (undeducted) dollars. This deviation permits tax-free dollars to be
invested and to earn a return. Though the return is nominally included in the tax base, it is
effectively free from tax (as under a consumption tax of the wage tax variety) between the time
the return is received and the underlying principal is repaid with after-tax dollars. More important,
while basis generally consists of previously taxed dollars to implement the precept that the same
dollars should not provide a double tax benefit for the same taxpayer, pre-tax borrowed dollars can
immediately create basis under Crane, which can be immediately deducted under § 179 or
1 See §§ 441(a) through (c); Treas. Reg. § 1.441-1(c)(1).
Chapter 20 Taxable Year Chapter 20
-654-
depreciated under §§ 167, 168, and 197.
The borrowing exclusion privilege was likely borrowed (pun intended) in the early days of the
income tax in a reflexive manner from financial accounting (under which borrowed funds are also
excluded from the “income” statement of businesses) before the differences between income
taxation and consumption taxation (and the E. Cary Brown yield-exemption phenomenon
discussed in Chapter 2) were well understood. It continues today, no doubt, because of the ease of
administration that the borrowing exclusion presents: the routine borrowing and repayment of
principal typically has no tax effects for either the borrower or lender. Nevertheless, this favorable
treatment, while perhaps necessary as an administrative matter, produces many well-known
distortions and opportunities for tax shelter activity, including those described above.
§ 61(a)(12) debt-discharge income
If borrowed cash were included in the tax base on receipt (contrary to current law), repayment
of principal would be deductible (also contrary to current law). In that pretend world, a borrower
who failed to repay principal would simply lose her repayment deduction, and we would need no
special tax rule to account for the failure to repay. Under real-world current law, however, the
failure to repay principal must generally create a Gross Income inclusion to prevent the complete
forgiveness of tax on the earlier “borrowed” amount (which would have been taxed indirectly
when repaid with undeducted, after-tax dollars), as you learned in Chapter 10. That is to say, the
obligation to repay was the only fact that prevented the earlier cash receipt from being included in
Gross Income upon receipt. Once the obligation to repay disappears, the justification for the earlier
exclusion also disappears. Under the annual accounting principle, however, the borrower is not
permitted to file an amended return for the earlier year (even if the statute of limitations remains
open) because exclusion was proper based on the facts known in that year (the expectation that
the amount would be repaid with after-tax dollars). Rather, we account for the changed
expectations by creating a Gross Income inclusion in that later year under § 61(a)(12) and the
annual accounting principle, which may, under certain circumstances, be excluded under § 108(a),
with reduction of tax attributes under § 108(b).
Receipts subject to a contingent obligation to repay
Because the borrowing exclusion is an extraordinary privilege, you learned in Chapter 9 that
taxpayers have attempted to exclude all sorts of cash receipts under it, such as embezzled and
extorted funds. James2 and North American Oil,3 however, combine to limit the borrowing
exclusion to those receipts accompanied by an unconditional obligation to repay that is recognized
by the parties at the time of transfer and receipt. Thus, even though an embezzler has a legal
obligation to repay embezzled funds if caught, embezzled funds are not excludable under the
borrowing exclusion. Repayment in a later year can raise a deduction issue in that later year under
the annual accounting principle.
North American Oil confirms that a receipt subject only to a contingent obligation to repay
(should certain facts arise) is usually includable immediately (in the year of receipt) under the
annual accounting principle. If the contingency ripens, resulting in repayment in a later year, the
changed circumstances will once again be dealt with in that later year, usually in the form of either
a § 165 deduction or § 1341 credit, under the annual accounting principle. You learned in Chapter
2 James v. U.S., 366 U.S. 213 (1961).
3 North Am. Oil Consol. v. Burnet, 286 U.S. 417 (1932).
Chapter 20 Taxable Year Chapter 20
-655-
5, however, that a major exception to this approach is found in § 83. The value of propert y received
as compensation for services rendered that may have to be repaid if certain contingencies ripen is
not included in Gross Income in the year of the property’s receipt. Rather, inclusion is delayed
until the substantial risk of forfeiture lapses, absent election under § 83(b). If the taxpayer makes
the § 83(b) election, which results in inclusion in the year of receipt under the usual approach that
receipts subject only to a contingent obligation to repay are immediately includable, the taxpayer
loses his deduction if the contingency ripens and repayment occurs (even though she wouldn’t lose
her deduction if the matter were analyzed under the common law rule rather than under the statute).
Depreciation recapture and the Arrowsmith doctrine
You learned in Chapter 13 that depreciation and amortization (under §§ 167, 168, and 197) and
§ 179 deductions are ordinary, offsetting high-taxed income. Because such deductions are
intentionally accelerated in many instances, depreciated assets can often be sold at a gain under §
1001 because of the § 1016(a)(2) basis reduction that accompanies such accelerated deductions.
Absent special rules, the resulting gain could often qualify as low-taxed capital gain because the
asset is often a capital asset or § 1231 property, resulting in tax arbitrage of the rate differential.
Thus, you learned in Chapter 14 that § 1245 (which would not be necessary absent the rate
reduction for net capital gain) recaptures the gain realized on the sale of non-real estate as ordinary
gain to the extent of prior depreciation. The depreciation recapture rule found in § 1250, however,
which applies to real property, is essentially a dead letter today.4
The Arrowsmith doctrine,5 also discussed in Chapter 14, operates under similar reasoning. A
current-year inclusion or deduction is capital to the extent that it effectively reverses the effect of
a prior-year capital gain inclusion or capital loss deduction. Mr. Arrowsmith paid a liability as the
successor in interest to a corporation that liquidated in an earlier year. If the corporation had paid
the liability in a timely manner before liquidation, Mr. Arrowsmith would have realized less capital
gain (or a larger capital loss) on the liquidation distribution that retired his stock. Thus, the Mr.
Arrowsmith’s transactionally related later payment must be characterized as a capital loss.
B. The tax benefit rule
The tax benefit rule is closely related to the analysis underlying depreciation recapture and the
Arrowsmith doctrine. While those rules address how to characterize a gain or payment (as
ordinary, capital, or § 1231 gain or loss) when it is transactionally related to an earlier inclusion or
deduction, the tax benefit rule generally addresses whether a current-year receipt must be included
in Gross Income at all in light of its transactional connection to an earlier payment or loss.
The tax benefit rule had its origins in the common law, as reflected in Dobson v. Commissioner,6
though it was later codified in § 111. Mr. Dobson purchased stock in 1929 in a public offering by
the corporation. Bad timing! After the crash, he sold the stock at substantial losses in 1930 and
1931. Even though the losses were listed as deductions on his tax returns, he enjoyed no tax benefit
4 The gain recaptured as ordinary income under § 1250 is the excess of actual depreciation taken over the amount that
would have been deduc ted using the straight-line method of depreciation. By requiring all real property put into service
after 1986 to be depreciated using the straight-line method, the Tax Reform Act of 1986 essentially rendered § 1250
impotent. Nevertheless, § 1(h) applies a maximum net capital gain rate of 25% (rather than 15% or 20%) to such gain
to the extent that it would have been recaptured as ordinary gain if § 1245 had applied. See Chapter 14, Part E.
5 This doctrine is named for the case that produced it: Commi ssioner v. Arrowsmith, 193 F.2d 734 (2d Cir. 1952).
6 320 U.S. 489 (1943).

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT