561 F. 2d 1287 - Prescott v. Commissioner of Internal Revenue

These two appeals, both of which turn on the validity of Treas.Reg. § 1.1361-16(b), have been consolidated for disposition in this Court.1 In both cases, taxpayers challenge the action of the Internal Revenue Service in treating the termination of elections by § 1361 "corporations" as resulting in taxable liquidations.

Under 26 U.S.C. § 1361,2 as enacted in 1954, a proprietor or partnership owning an unincorporated business enterprise could elect to be treated as a corporation for tax purposes. The election could be made within sixty days of the close of any taxable year; it was irrevocable. The petitioner in No. 76-1634, Edward J. Prescott, a Minnesota securities dealer, conducts business as a sole proprietorship under the name Edward J. Prescott & Co. He first elected to be taxed as a corporation under § 1361 for taxable year 1954. The appellee in No. 77-1084, L. W. Simpson, is sole proprietor of an Iowa trucking business known as the Mid-Seven Transportation Co. He first elected under § 1361 to be taxed as a corporation for taxable year 1960. During the years in which the elections were effective, both taxpayers reported income of their businesses as if they were corporations and paid taxes on that portion of their income at corporate rates.

Very few owners of unincorporated businesses availed themselves of the special treatment accorded by § 1361. Because of this, and the complexity of the problems in its administration, Congress repealed § 1361 in 1966.3 No new elections were allowed after the date of passage of the repealer, April 14, 1966. 26 U.S.C. § 1361(a). Elections previously made could be voluntarily revoked. 26 U.S.C. § 1361(n)(1). Any election not voluntarily revoked would be automatically terminated on January 1, 1969. 26 U.S.C. § 1361(n)(2).

A taxpayer who transferred the assets of his proprietorship to a de jure corporation after revocation of the election could limit the income tax consequences of revocation. 26 U.S.C. § 1361(m); Treas.Reg. §§ 1.1361-16(a) (2), -16(b). However, in the absence of transfer to a corporation, "the section 1361 corporation and its owners (would) be treated as if the corporation had distributed its assets in a complete liquidation on January 1, 1969." Treas.Reg. § 1.1361-16(b).4 The complete liquidation of a corporation is treated by a taxpayer as payment in full in exchange for his stock. 26 U.S.C. § 331(a)(1). Income is realized on such a liquidation to the extent that the amount realized exceeds the taxpayer's adjusted basis in his shares. 26 U.S.C. § 1001 et seq.

In the two cases on appeal, neither Prescott nor Simpson voluntarily revoked his § 1361 election prior to January 1, 1969. The elections therefore terminated by operation of law on that date. Neither taxpayer incorporated his business; both reported income as proprietorships for 1969 and the following years. Of most significance, neither taxpayer reported a gain from liquidation for 1969, as required by Treas.Reg. § 1.1361-16(b).

The Commissioner assessed a $108,051.78 deficiency against Prescott for 1969 based on failure to report a gain from liquidation. Prescott petitioned the Tax Court for review, challenging the validity of that portion of § 1.1361-16(b) which requires corporate liquidation treatment on the termination of a § 1361 election. The Tax Court sustained the position of the Commissioner, finding that the regulation "is eminently reasonable and consistent with the legislative intent * * *." Prescott appeals.

The Commissioner assessed Simpson with deficiencies for 1969 and 1971 totaling $55,100.70, based on the failure to report a gain from liquidation. Simpson paid the assessments, and sued for refund in the United States District Court for the Southern District of Iowa. The Court found that the regulation was invalid for lack of authorization, inconsistency with the governing statute, unreasonableness, and improper retroactivity. The Court found that Simpson was therefore entitled to a refund; the United States appeals.

We conclude that the challenged regulation is valid. We therefore affirm the judgment of the Tax Court in No. 76-1634, and reverse the judgment of the District Court in No. 77-1084.

Taxpayers contend that § 1.1361-16(b) is an invalid interpretation of 26 U.S.C. § 1361, because it is inconsistent with the purpose of the statute, unauthorized, and unreasonable. Alternatively, they contend that the regulation unconstitutionally imposes an unapportioned direct tax on something other than income, and imposes a retroactive tax.

The burden of establishing the invalidity of the regulation lies with the taxpayers. See Dixon v. United States, 381 U.S. 68, 79, 85 S.Ct. 1301, 14 L.Ed.2d 223 (1965); Danly Machine Corp. v. United States, 356 F.Supp. 1284, 1290 (N.D.Ill.1972), aff'd, 492 F.2d 30 (7th Cir. 1974). The burden is a heavy one. "Treasury regulations constitute contemporaneous construction by those charged with administration of these statutes and should not be overruled except for weighty reasons." Kahler Corp. v. Commissioner, 486 F.2d 1, 4 (8th Cir. 1973). We consider in turn the arguments advanced by taxpayers to show the regulation to be invalid.I.

One ground for finding a Treasury regulation invalid is inconsistency with the Internal Revenue Code itself. A regulation which is "plainly inconsistent" with the governing statute is invalid as an improper exercise of the power delegated the Secretary by Congress. See United States v. Cartwright, 411 U.S. 546, 557, 93 S.Ct. 1713, 36 L.Ed.2d 528 (1973); Commissioner v. South Texas Lumber Co., 333 U.S. 496, 501, 68 S.Ct. 695, 92 L.Ed. 831 (1948); World Service Life Insurance Co. v. United States, 471 F.2d 247, 250 (8th Cir. 1973).

Taxpayers argue that there is inconsistency here because the code is silent on the question of liquidation treatment on the termination of § 1361 status, and the regulation expressly imposes such treatment. They argue that imposing liquidation treatment is inconsistent with the original purpose of § 1361, which was to give the benefit of corporate treatment to certain small businessmen, without compelling them to accept corporate form. Mathis v. United States, 430 F.2d 158, 160 (7th Cir. 1970); Estate of Willett v. Commissioner of Internal Revenue, 365 F.2d 760, 762 (5th Cir. 1966).5

Whatever might have been the intent of the 1954 Congress which enacted § 1361, it was clearly the intention of Congress in 1966 when it repealed the section to impose liquidation treatment on the termination of § 1361 status. The Senate Finance Committee Report, S.Rep.No. 1007, 89th Cong., 2d Sess. 1, 22, (reprinted in) 1966-2 U.S.Code Cong. & Admin.News pp. 2141, 2151, stated:

The revocation or termination of an election (without any transfer to an actual corporation) under your committee's amendment will be treated, for Federal income tax purposes, as a complete liquidation of a corporation.

The committee report, as the "considered and collective understanding of those Congressmen involved in drafting and studying proposed legislation", is of great value in determining congressional intent. Zuber v. Allen, 396 U.S. 168, 186, 90 S.Ct. 314, 324, 24 L.Ed.2d 345 (1969); Housing Authority of Omaha v. United States Housing Authority, 468 F.2d 1, 6 n. 7 (8th Cir. 1972), cert. denied, 410 U.S. 927, 93 S.Ct. 1360, 35 L.Ed.2d 588 (1973).6 The regulation is consistent with that clearly manifested intent.

Taxpayer Simpson contends that the regulation is invalid because the Secretary was without authority to promulgate it. The necessary authority is to be found, if at all, in 26 U.S.C. § 7805, which provides in pertinent part:

(a) Authorization. Except where such authority is expressly given by this title to any person other than an officer or employee of the Treasury Department, the Secretary or his delegate shall prescribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue.

Congress created § 1361, providing that electing businesses would be treated as corporations "with respect to operation, distributions, sale of an interest, and any other purpose". 26 U.S.C. § 1361(c). It thereafter repealed this special provision, without providing details on the tax effects of this termination. It was "needful" in order "to carry out the will of Congress" that regulations defining effects be promulgated. Particularly where an unequivocal manifestation of congressional intent that termination be treated as a liquidation appears, the regulation was within the scope of the Secretary's authority. See Commissioner v. Bilder, 369 U.S. 499, 502, 82 S.Ct. 881, 8 L.Ed.2d 65 (1962).

Taxpayer Simpson contends that § 7805 delegates the power to promulgate interpretive, but not legislative, regulations. He argues that Treas.Reg. § 1.1361-16, because it imposes a tax which is not expressly mentioned by statute, is legislative.

It is true that the power to adopt regulations is not the power to make law, but is the power to carry into effect the will of Congress as expressed by statute. Dixon v. United States, 381 U.S. 68, 74, 85 S.Ct. 1301, 14 L.Ed.2d 223 (1965); United States v. Levy, 533 F.2d 969, 973 (5th Cir. 1976). Where as here, however, the statute is silent as to the tax treatment to be given as a result of the legislative event, a regulation which gives effect to the intent of Congress clearly expressed in the legislative history is proper. See, e. g., Commissioner v. Bilder, 369 U.S. 499, 82 S.Ct. 881, 8 L.Ed.2d 65 (1962); Fulman v. United States, 545 F.2d 268 (1st Cir. 1976).

Taxpayers argue that even a regulation promulgated pursuant to proper authority, and not inconsistent with the governing statute, may be invalidated if it is "unreasonable." This position finds authority in the formulation: If a Treasury Regulation "is a reasonable interpretation of the (Internal Revenue Code) and as such does not distort the intent of Congress, then it must be sustained * * * ." World Service Life Ins. Co. v. United States, 471 F.2d 247, 250 (8th Cir. 1973). Regulations have on occasion been held invalid on grounds of unreasonableness alone. Allison v. United States, 379 F.Supp. 490, 493 (M.D.Pa.1974); Smith v. United States, 301 F.Supp. 1016, 1022 (S.D.Fla.1969). But even if this is adequate ground for striking down a regulation, it does not avail taxpayers here; this regulation is not unreasonable.

Taxpayers' argument for unreasonableness is based on the proposition that a proprietor should not be subjected to liquidation treatment when he continues to carry on his business. There is, as the Tax Court noted in Prescott, some inequity in this result. Neither Prescott nor Simpson was in any different situation on January 1, 1969, than he was on December 31, 1968. Both taxpayers conducted their businesses exactly as they had before; there is no indication that either taxpayer transferred business assets to personal use. Yet, both taxpayers were taxed as of that date on the appreciation in value of their businesses.

The alternative treatment advanced by taxpayers is, however, at least as inequitable. Taxpayers seek to change from corporate to unincorporated tax status with no consequences to themselves. They had the benefit of fictional corporate identities, and corporate tax rates, from the time of their § 1361 elections; that is, from 1954 in Prescott's case and from 1960 in Simpson's. A condition of this benefit was that the businesses would be treated as corporations for all purposes, including distributions. 26 U.S.C. § 1361(c). Not to tax appreciation in value of the businesses on termination of this fictional corporate treatment would mean that taxpayers would escape the cost exacted from them for the benefit of corporate treatment. This would be an unmerited windfall.

It appears that Congress and the Secretary were faced with two choices as to proper treatment of this termination, neither entirely satisfactory. The choice to treat the termination as a liquidation cannot be termed unreasonable.

We hold that Treas.Reg. § 1.1361-16(b) is reasonable, consistent with statutory purpose, and authorized by statute. The only remaining question is whether it meets constitutional requirements.

U.S.Const. Art. I, § 9, cl. 4 prohibits Congress from levying unapportioned direct taxes. The Sixteenth Amendment made an exception to the apportionment requirement for taxes levied on incomes.7 It therefore becomes important to determine whether there is income here on which an unapportioned tax may constitutionally be laid.

The argument that a particular benefit to the taxpayer is not income in this constitutional sense is not a new one. It was first made in Eisner v. Macomber, 252 U.S. 189, 207, 40 S.Ct. 189, 64 L.Ed. 521 (1920). There the Court found Congress' attempt to tax stock dividends to be unconstitutional, because no income was present; income being "the gain derived from capital, from labor, or from both combined". 252 U.S. at 207, 40 S.Ct. at 193. A stock dividend was not income because nothing had been derived, that is, severed from the taxpayer's investment and drawn or received by him. This was the determinative fact. Id.

If Eisner stood undiminished by subsequent decisions, it would offer strong support to taxpayers' position. However, the Supreme Court has found it necessary to abandon the attempt at an all-inclusive definition of income which it had undertaken in Eisner. See 1 J. Mertens, Law of Federal Income Taxation, § 5.03 (1974). In Helvering v. Bruun, 309 U.S. 461, 60 S.Ct. 631, 84 L.Ed. 864 (1940), the Court held that a lessor realized income on the termination of a lease in the value of any improvements to the land made by the lessee, notwithstanding the improvements were not severed from the land. The Court thus abandoned the idea that gain must be severed from capital to be taxable. See also Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431, 75 S.Ct. 473, 99 L.Ed. 483 (1955) (noting this change).

In place of the concept of severance, the Court, in determining whether there has been income, now looks to determine if there has been a "taxable event." United States v. Davis, 370 U.S. 65, 67, 82 S.Ct. 1190, 8 L.Ed.2d 335 (1962); Commissioner v. Glenshaw Glass Co., supra, 348 U.S. at 431, 75 S.Ct. 473. The question asked is whether some event has occurred which marks an appropriate time to tax the increase in value of assets. United States v. Davis, supra.

The requirement of a taxable event has been satisfied here. The action of Congress, as a result of which the taxpayers' businesses, which had fictional corporate status, returned to taxation as proprietorships, created an event upon which it was appropriate to tax the increase in value of those businesses. We conclude therefore that the tax was protected from Article I, § 9 by the income exception contained in the Sixteenth Amendment.8B. Retroactivity

Taxpayers contend that imposition of liquidation treatment as of January 1, 1969, is an improper retroactive tax, because it taxes income from prior years. Even if it is assumed that a tax on prior years' appreciation is retroactive, the contention is frivolous. An income tax statute may apply retroactively without violation of the Constitution. Brushaber v. Union Pacific R. R. Co., 240 U.S. 1, 20, 36 S.Ct. 236, 60 L.Ed. 493 (1916); Shanahan v. United States, 447 F.2d 1082, 1083 (10th Cir. 1971); First National Bank in Dallas v. United States, 190 Ct.Cl. 400, 420 F.2d 725, 729, cert. denied, 398 U.S. 950, 90 S.Ct. 1868, 26 L.Ed.2d 289 (1970)). Moreover, as the government notes in its briefs, the taxable event the termination of the election occurred after the enactment of the statute and the regulation.

Taxpayers have not sustained their burden of showing § 1.1361-16(b) to be an invalid interpretation of the Internal Revenue Code or a violation of the Constitution. Therefore, the judgment of the Tax Court in favor of the Commissioner in No. 76-1634 is affirmed; the judgment of the District Court in favor of taxpayer Simpson in No. 77-1084 is reversed.9