HILLSBORO NATIONAL BANK, PETITIONER V. COMMISSIONER OF INTERNAL REVENUE UNITED STATES OF AMERICA, PETITIONER V. BLISS DAIRY, INC. No. 81-485 No. 81-930 In the Supreme Court of the United States October Term, 1981 On Writs of Certiorari to the United States Courts of Appeals for the Seventh and Ninth Circuits Brief for the Commissioner in No. 81-485 and the United States in No. 81-930 TABLE OF CONTENTS Opinions below Jurisdiction Statutes and regulation involved Statement Summary of argument Argument: I. The tax benefit rule requires a taxpayer to restore to income previously deducted items once subsequent events establish the invalidity of the factual premise upon which the prior year's deduction was claimed, whether or not the taxpayer actually recovers money or property A. The tax benefit rule is a necessary element of the annual accounting system B. The courts developed the tax benefit rule in order to offset the benefit of a deduction for expenses or losses which subsequent events establish will not be incurred II. The personal property taxes previously deducted by Hillsboro Bank should be restored to income when the amounts it paid into escrow were refunded to its shareholders on whose behalf they had been deposited III. The amounts previously deducted by Bliss Dairy that are attributable to cattle feed unconsumed in its business and distributed to its shareholders on liquidation should be restored to its taxable income for its year of liquidation A. A corporation's distribution of previously deducted cattle feed to its shareholders refutes the assumptions underlying the corporation's claim to deductions for the cost of that feed B. At all events, even if an "actual recovery" is required for the application of the tax benefit rule, Bliss Dairy enjoyed such a recovery Conclusion Appendix OPINIONS BELOW No. 81-485. The opinion of the Tax Court (H. Pet. App. A-21 to A/ 48) /1/ is reported at 73 T.C. 61. The opinion of the court of appeals (H. Pet. App. A-1 to A-20) is reported at 641 F.2d 529. No. 81-930. The opinion of the district court (B. Pet. App. 1a) is not reported. The opinion of the court of appeals (B. Pet. App. 2a-5a) is reported at 645 F.2d 19. JURISDICTION No. 81-485. The judgment of the court of appeals was entered on February 25, 1981 (H. Pet. App. A-47 to A-48). A petition for rehearing and rehearing en banc was denied on June 9, 1981 (H. Pet. App. A-49 to A-50). The petition for a writ of certiorari was filed on September 5, 1981, and granted on January 18, 1982. The jurisdiction of this Court rests on 28 U.S.C. 1254(1). No. 81-930. The judgment of the court of appeals was entered on May 11, 1981 (B. Pet. App. 6a). The government's petition for rehearing was denied on July 31, 1981 (B. Pet. App. 7a). On October 2, 1981, Justice Rehnquist extended the time within which the government could file a petition for a writ of certiorari to November 21, 1981. The petition was filed on November 16, 1981, and granted on January 18, 1982. The jurisdiction of this Court rests on 28 U.S.C. 1254(1). STATUTES AND REGULATION INVOLVED The relevant provisions of Sections 164, 332, 333, 334, 336 and 337 of the Internal Revenue Code of 1954 (26 U.S.C (& Supp. III)), and Section 1.164-7 of the Treasury Regulations on Income Tax (1954 Code) (26 C.F.R.), are set forth in the Appendix, infra, 1a-4a. QUESTIONS PRESENTED No. 81-485. Whether the tax benefit rule required a bank to include in gross income the amount of a state tax that it had paid in a previous taxable year on behalf of its stockholders, and for which it had taken a federal income tax deduction, when it was subsequently determined that the state tax was not owing and the tax was refunded directly to the bank's stockholders in the taxable year at issue. No. 81-930. Whether the tax benefit rule required a liquidating corporation to include in gross income for the year of its liquidation, an amount equal to the value of uncomsumed cattle feed it distributed to its shareholders, where the corporation had previously deducted the cost of that feed in full, and where the shareholders acquired a "stepped-up" basis in the feed enabling them to claim a further deduction for the feed when it was consumed during their subsequent operation of the business in non-corporate form. STATEMENT No. 81-485. Petitioner Hillsboro National Bank is a national banking association with its principal place of business in Hillsboro, Illinois. Prior to 1971, the stockholders of incorporated banks located within Illinois were subject to a personal property tax on the value of their shares. Ill. Ann. Stat. ch. 120, Section 557 (Smith-Hurd 1970). The banks, however, were themselves required to retain dividends sufficient to pay those taxes. Ill. Ann. Stat. ch. 120, Section 558 (Smith-Hurd 1970). Rather than retaining dividends, Illinois banks customarily paid the taxes on behalf of their stockholders (H. Pet. App. A-2, A-23 to A-24). In 1970, Illinois amended its constitution, effective January 1, 1971, to prohibit ad valorem taxation on personal property owned by individuals. In July 1971, however, the Illinois Supreme Court held the amendment invalid on the ground that it violated the Equal Protection Clause of the Fourteenth Amendment to the United States Constitution. Lake Shore Auto Parts Co. v. Korzen, 49 Ill. 2d 137, 273 N.E.2d 592 (1971). After this Court granted certiorari in that case (405 U.S. 1039), Illinois enacted a statute directing that the disputed property taxes be deposited in an interest-bearing escrow account pending final resolution of the Lake Shore case, and further providing that full repayment would be made to the taxpayers "for whom such tax payments are placed in escrow" if the taxes were "ultimately held to be invalid" (Ill. Ann. Stat. ch. 120, Section 676.01 (Smith-Hurd Cum. Supp. 1981)) (H. Pet. App. A-3, A-26 to A-27). On July 7, 1972, Hillsboro Bank paid $26,110.32 to the County Collector of Montgomery County, Illinois, in satisfaction of the 1971 personal property taxes owed by its individual stockholders on their bank shares. On its 1972 tax return, the Bank claimed a deduction for these tax payments pursuant to Section 164(e) of the Internal Revenue Code of 1954 (26 U.S.C.) (H. Pet. App. A-3, A-4, A-23 to A25). /2/ In February 1973, this Court reversed the Illinois Supreme Court, holding that the Illinois constitutional amendment prohibiting the imposition of such taxes was valid. Lehnhausen v. Lake Shore Auto Parts Co., 410 U.S. 356. Acting upon the advice of the Illinois States Attorney and the Illinois Department of Local Government Affairs, the County Treasury of Montgomery County, Illinois, thereupon refunded $26,697.79 (representing the $26,110.32 in erroneously collected personal property taxes, plus $587.47 in accrued interest) directly to the Bank's individual stockholders. The Bank did not include any portion of the refunded amount in gross income as reported on its return for its taxable year ended December 31, 1973 (H. Pet. App. A-27 to A-29). On audit, the Commissioner of Internal Revenue determined that the entire sum refunded to the shareholders was includible in the Bank's gross income for 1973 under the tax benefit rule because the tax refund in 1973 was inconsistent with the Bank's claimed deduction of the state tax in 1972. In this proceeding brought by the Bank for redetermination of the Commissioner's deficiency, the Tax Court ruled that the amount previously deducted (but not the accrued interest) was properly included in the Bank's income for 1973 under the tax benefit rule. The Court reasoned that otherwise the Bank would be able to retain the benefit of a deduction for what was, in ultimate effect, a dividend distribution (H. Pet. App. A-21 to A-46). The court of appeals affirmed, with one judge dissenting (H. Pet. App. A-1 to A-20). Adhering to its earlier decision in First Trust and Savings Bank v. United States, 614 F.2d 1142 (7th Cir. 1980), in which it had applied the tax benefit rule in almost identical circumstances, the court held that the tax benefit rule should be applied where "there is either an actual recovery of a previously deducted amount or some other event inconsistent with the prior deduction" (H. Pet. App. A-7). It concluded that the latter ground "applies foursquare in this case" because the state tax refund had "transformed a tax payment deductible under Sec. 164(e) into a nondeductible cash dividend to the Bank's stockholders" (H. Pet. App. A-8). No. 81-930. Respondent Bliss Dairy, Inc. was a closely held Arizona corporation engaged in the business of operating a dairy. It kept its books and filed its income tax returns using a cash method of accounting, with a fiscal and taxable year beginning on July 1 and ending June 30. During its taxable year ending June 30, 1973, Bliss purchased $150,199 worth of cattle feed for use in its dairy operations. In accordance with its cash method of accounting, it deducted the full cost of the feed from its gross income as a business expense on its 1973 return, even though a substantial portion of the feed had not yet been consumed by the end of that year (B. Pet. App. 2a-3a). On July 2, 1973, two days into the following taxable year, Bliss adopted a plan of liquidation pursuant to Section 333 of the Internal Revenue Code of 1954. /3/ In accordance with that plan, Bliss, during the month of July 1973, distributed all of its assets pro rata to its shareholders, who thereafter continued to operate the dairy business in non-corporate form. Among the assets so distributed was the unconsumed cattle feed that Bliss deducted as an expense for the preceding taxable year. That feed had an adjusted basis in the hands of the corporation of zero because it had previously deducted the full cost of the feed. As a result of the liquidation, however, the shareholders acquired "stepped-up" tax bases in the feed, thereby allowing them the benefit of further deductions on their individual tax returns for the period in which the feed was actually consumed (B. Pet. App. 3a). /4/ On audit of Bliss' federal income tax return for its final taxable year (July 1, 1973 through July 31, 1973), the Commissioner of Internal Revenue increased Bliss' gross income by $60,000, representing his determination of the value of the unconsumed feed that Bliss distributed to its shareholders. /5/ Bliss paid the resulting assessment and brought this refund suit in the United States District Court for the District of Arizona. Although the district court agreed that the Commissioner's determination was correct, it considered itself bound by the Ninth Circuit's prior decision in Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (1963), and stated that it would follow that case "until such time as it is overruled" (B. Pet. App. 1a). The court of appeals affirmed on the authority of its prior decision in South Lake Farms. There, it had declined to apply the tax benefit rule in comparable circumstances involving the liquidation of a subsidiary corporation into its parent under Section 322 of the Code. In adhering to its decision in South Lake Farms, the court of appeals acknowledged that "(r)ecent decisions in the Courts of Appeals of other circuits are in conflict with our holding in South Alke Farms" (B. Pet. App. 4a). /6/ SUMMARY OF ARGUMENT I A. One of the fundamental principles upon which the federal income tax is based is the annual accounting system, which draws arbitrary lines between taxable periods. In so doing, the annual accounting system necessarily rejects a transactional approach under which tax consequences await the completion of each particular transaction, rather than the close of a taxable period. The firm lines of demarcation between taxable periods will inevitably produce situations in which the taxpayer may be required to report income or may be entitled to claim deductions for a particular year even though events occurring in a subsequent year may affect the amount of income actually enjoyed or the outlays or losses ultimately incurred. The proper remedy for taking account of such changed circumstances is not to amend or modify the original return, but rather to reflect the change on the return covering the later period during which the offsetting events actually occurred. See, e.g., Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365 (1931); Healy v. Commissioner, 345 U.S. 278 (1953). In response to the requirements of the annual accounting system, the courts have developed the "tax benefit rule" to deal with such subsequent year reportings. The rule is designed to ensure a measure of tax parity in the effect of an earlier deduction and later correcting entry. Under the tax benefit rule, the required correction for expenses that are deducted but not ultimately incurred is for income in the later year to be increased by the amount of the prior deduction. The tax benefit rule at issue in these cases requires the restoration of a prior year's deduction to income when subsequent events establish the invalidity of the factual premise on which the prior year's deduction was claimed. In Hillsboro National Bank, the taxpayer-bank paid certain state personal property taxes on behalf of its shareholders and claimed a deduction for those taxes in 1972. After it was determined that the taxes were not due and owing, the State refunded the taxes directly to the shareholders in 1973. In Bliss Dairy, the taxpayer-corporation purchased cattle feed for use in its business. In accordance with an accounting convention, it deducted the full cost of the feed as a business expense. In the following tax year, however, the corporation liquidated and distributed unconsumed cattle feed for which it had previously taken a deduction. These after-arising inconsistent events -- the refund of the state taxes and the distribution of the unconsumed feed -- eliminate the factual premises upon which the taxpayers claimed the prior years' deductions. If a state tax turns out not to be due, there is no justification for the bank's retaining the benefits of a deduction premised on its payment. And if cattle feed will not be used in a corporation's business, the corporation must restore the deduction to its income when the fact of non-consumption by the corporation becomes apparent. In sum, the subsequent events in both cases demonstrate that the taxpayers were not entitled to the deductions that they originally claimed. B. The taxpayers here acknowledge the existence of the tax benefit rule but resist its application in these cases on the ground that they did not enjoy an actual recovery of money or property. Thus, Hillsboro Bank argues that it should not be required to restore its deduction for state taxes to income because the state tax refund was paid to its shareholders, rather than to itself. Likewise, Bliss Dairy contends that the deduction for unconsumed cattle feed should not be restored to income because it received nothing when it distributed the feed to its shareholders upon liquidation. But both taxpayers misjudge the purpose of the tax benefit rule. That rule does not depend upon an actual recovery of money or property. The early cases that developed the tax benefit rule did not turn upon the identification and taxation of economic benefits that could be considered to be actual current taxable income. Rather, the courts recognized that the tax benefit rule is a remedial device designed to assure that a taxpayer's income over a period encompassing several taxable years is accurately reflected where subsequent events establish that no loss or expenses will actually be incurred. For example, an early case required, on tax benefit principles, a taxpayer to restore to income a previously claimed depletion deduction taken in anticipation of exhaustion of her property's oil reserve when the lease she had granted expired without any production ever having taken place. Barnett v. Commissioner, 39 B.T.A. 864 (1939). /7/ There, it is plain that no "actual recovery" of money or property occurred. The taxpayer had to recognize income in the current year not because she actually received anything that might be characterized as income in the current year for she plainly had not. Rather, income recognition was necessary to balance out the prior deduction that was allowed in anticipation of events that did not ultimately occur. As the Board of Tax Appeals stated, "(w)hen some event occurs which is inconsistent with a deduction taken in a prior year, adjustment may have to be made by reporting a balancing item in income for the year in which the change occurs" (39 B.T.A. at 867). Hence, the tax benefit rule is a mechanism for putting right the imbalance caused by a change in circumstances undermining the premise on which previously claimed deductions were based. Thus, the taxpayers in these cases are treated as realizing income only because they deducted amounts that prove to have exceeded their actual loss or cost. Since the basis of the tax benefit rule is the need to correct the income distortion caused by a taxpayer's having claimed a deduction which, in light of hindsight, exceeded his actual expenses, it follows that the rule should apply on the occurrence of any event that refutes the correctness of the factual assumptions underlying a previously claimed deduction. Although an actual recovery is the usual type of event that triggers application of the tax benefit rule, the cases establish that such recovery is not the only type of event that requires restoration of a prior year's deduction. II Viewed from this perspective, it is plain that Hillsboro Bank must restore its prior deduction for state taxes to its income, even if it is not deemed to have received an actual recovery of money or property. Here, the refund of the amounts previously paid on behalf of the Bank's shareholders for satisfaction of the personal property tax liability negates the factual premise upon which the Bank previously deducted such amounts pursuant to Sections 164(e) and 461(f) of the Code. In enacting the latter provision permitting the current deduction of contested liabilities, Congress explicitly stated its understanding that any "overstatement of the deduction" would be restored to income "in the year in which the liability is finally determined" S. Rep. No. 830, 88th Cong., 2d Sess. 100 (1964). Hence, the tax benefit principle was ratified by Congress as applicable to the circumstances here. The fact that the refund was paid directly to the shareholders, rather than to the Bank alone, or to the Bank and its shareholders jointly, is not a sufficient basis for allowing the Bank the continuing benefit of its prior deduction. The particular identity of the recipient of the refund is of no moment. For purposes of the tax benefit rule, the critical fact is that the determination of nonliability and the consequent tax refund (whether to the Bank or to its shareholders) are events that are inconsistent with, and eliminate the justification for, the allowance of a deduction to any party under Section 164. Indeed, as the court below recognized (H. Pet. App. A-8), the ultimate result was to transform the escrow deposit into a dividend from the Bank to the shareholders. Thus, unless the tax benefit rule applies to restore the prior deduction to the Bank's income, the Bank will obtain the wholly improper benefit of a tax deduction for a dividend distribution to its shareholders. The corrective tax benefit rule is designed to prevent such an anomaly. /8/ III The corrective tax benefit rule likewise applies to Bliss Dairy. On its return for its taxable year ending June 30, 1973, Bliss Dairy deducted the full cost of $150,199 worth of cattle feed that it had purchased in that year. This deduction was based on the assumption that the feed would ordinarily be consumed within a relatively short time in the course of the operation of its business. However, only $93,634 of the feed was consumed in the year for which the deduction was claimed. On the second day of the next taxable year, Bliss Dairy liquidated and distributed the remaining $56,565 worth of previously-deducted feed to its shareholders. This distribution in kind of unconsumed feed eliminated the basis for the original assumption underlying Bliss Dairy's earlier deduction, i.e., that the feed would be consumed in the ordinary course of its business. If Bliss Dairy had used the feed for its shareholders' personally-owned cattle, the deduction would be restored to its income. Accordingly, Bliss Dairy's liquidating transfer of the feed was likewise an appropriate event for applying the tax benefit rule to require a restoration of the amount deducted for the distributed feed in the prior year. Indeed, the case for application of the tax benefit rule is considerably enhanced by the fact that absent restoration of the deduction, there will be a double deduction for the same cattle feed. As this Court reaffirmed in United States v. Skelly Oil Co., 394 U.S. 678, 684 (1969), "the Code should not be interpreted to allow * * * 'the practical equivalent of double deduction' * * * , absent a clear declaration of intent by Congress." But unless the tax benefit rule applies in this case, the result would not simply be "the practical equivalent" of a double deduction but a double deduction in fact. Here, the shareholders of Bliss Dairy who continued its business in noncorporate form took a "stepped-up" basis in the cattle feed computed by reference to the basis of their stock in the corporation under Section 334(c) of the Code. They quite properly deducted the amount of that basis when the feed was consumed in the course of their business. In a prior year, however, Bliss Dairy claimed a similar deduction for the cost of the feed. In these circumstances, Bliss Dairy must restore to its own income the amount previously deducted for that portion of the feed that was not ultimately used in its trade or business but rather in the trade or business of its shareholders. Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (9th Cir. 1963), upon which the decision below relied, is not cogent authority for the proposition that the tax benefit rule requires a recovery of money or property. There, in a prior decision the court of appeals stated that "(n)owhere in the Code do we find an intent that gains to the stockholders were to be attributed to the corporation, much less that they were to be treated as ordinary income to the corporation" (324 F.2d at 389). But the court below misunderstood why Bliss Dairy should be required to recognize income in the current taxable year. The government is not seeking to attribute to Bliss Dairy the gains of its shareholders. Rather it is Bliss Dairy's own ordinary income that the government seeks to restore to taxable income -- i.e., the income that escaped tax in the prior taxable year as a result of the deduction for cattle feed that would be consumed only in subsequent periods. Once subsequent events made it clear that the anticipated event on which the deduction was based would not occur, such a restoration to income is required under the tax benefit rule. /9/ ARGUMENT I THE TAX BENEFIT RULE REQUIRES A TAXPAYER TO RESTORE TO INCOME PREVIOUSLY DEDUCTED ITEMS ONCE SUBSEQUNET EVENTS ESTABLISH THE INVALIDITY OF THE FACTUAL PREMISE UPON WHICH THE PRIOR YEAR'S DEDUCTION WAS CLAIMED, WHETHER OR NOT THE TAXPAYER ACTUALLY RECOVERS MONEY OR PROPERTY A. The Tax Benefit Rule Is A Necessary Element Of The Annual Accounting System 1. A fundamental principle upon which the federal income tax is based is the annual accounting system. See Section 441 of the Internal Revenue Code of 1954. As the Court stated in Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365 (1931), "It is the essence of any system of taxation that it should produce revenue ascertainable, and payable to the government, at regular intervals. Only by such a system is it practicable to produce a regular flow of income and apply methods of accounting, assessment, and collection capable of practical operation." The annual accounting system draws arbitrary lines between taxable periods. In so doing, it necessarily rejects a transactional approach under which tax consequences await the completion of each particular transaction, rather than the close of a taxable period. Accordingly, "(i)t is settled that each 'taxable year' must be treated as a separate unit, and all items of gross income at and deduction must be reflected in terms of their posture the close of such year." United States v. Consolidated Edison Co., 366 U.S. 380, 384 (1961). The firm demarcation between taxable periods necessarily produce situations in which the taxpayer may be required to report income or may be entitled to claim deductions for a particular year even though events occurring in a subsequent year may affect the amount of income actually enjoyed or the liabilities or losses ultimately incurred. Since this Court's decision in Burnet v. Sanford & Brooks Co., supra, it has been established that the proper adjustment for such changed circumstances is not to be made in the year in which the item of income was originally reported or the deduction claimed, but rather by means of a corrective entry for the year in which the change of circumstance occurs. For example, in North American Oil v. Burnet, 286 U.S. 417 (1932), this Court held that when a taxpayer recieves income in one year under a "claim of right," that amount is includable in gross income for the year of receipt, even though the taxpayer is divested of the income in a subsequent year. North American Oil made equally clear that the subsequent divestment of such an item of income would give rise to a deduction in the subsequent year. As the Court there explained, "(i)f in 1922 the Government had prevailed, and the company had been obliged to refund the profits received in 1917, it would have been entitled to a deduction from the profits of 1922, not from those of any earlier year * * * " (id. at 424). See also United States v. Lewis, 340 U.S. 590 (1951); Healy v. Commissioner, 345 U.S. 278 (1953); United States v. Skelly Oil Co., 394 U.S. 678, 680-681 (1969). See generally 1 B. Bittker, Federal Taxation of Income, Estates and Gifts, Paragraphs 6.3.1 through 6.3.4 (1981). /10/ The tax benefit rule involved in these cases is the converse of the claim of right doctrine established by this Court in North American Oil and to which the Court adverted at the conclusion of its opinion in that case. For just as the claim of right doctrine requires the reporting of income based upon the circumstances known to exist at the end of the particular period, the tax benefit rule entitles a taxpayer to enjoy the benefit of whatever deductions appear to be proper based upon the circumstances that exist at the end of the taxable period. In both cases, however, subsequent events require corrective adjustments to be made in later years. Thus, when a taxpayer receives income subject to a claim of right and reports it in year 1, he may claim a deduction for year 2 if he must return or relinquish the item of income in that later year. Conversely, where a taxpayer obtains a tax benefit for a deduction claimed in year 1 and it is established in year 2 that the anticipated loss or expense for which the deduction is claimed will not be incurred, he must restore the deduction to income in year 2. See, generally, 1 B. Bittker, supra, Paragraph 5.7.1. As the tax benefit rule originally developed, it dealt primarily with the inclusion in gross income of previously deducted amounts such as debts that had been written off as worthless and that were later collected. See, e.g., Putnam National Bank v. Commissioner, 50 F.2d 158 (5th Cir. 1931). Absent the prior deduction, there would of course be no occasion for classifying the collection of a debt as a taxable event. Hence, a controversy early arose as to whether full restoration to income of the previously deducted amount would be justified to the extent the deduction had not led to a "tax benefit" in the earlier year. That question, however, was put to rest in 1942 with the adoption of Section 22(b)(12) (Act of Oct. 21, 1942, ch. 619, 56 Stat. 812) of the Internal Revenue Code of 1939 (26 U.S.C. (1952 ed.)) (the predecessor to Section 111 of the 1954 Code), which specifically provided for the exclusion from income of subsequently recovered bad debts, prior taxes and "delinquency amounts" to the extent that prior credits or deductions did not give rise to an actual tax benefit. /11/ See Dobson v. Commissioner, 320 U.S. 489, 505 (1943). Indeed, while the "inclusionary" principles outlined above had already become firmly established by that time, the term "tax benefit rule" appears to have originated and to have been first applied in the context of the exclusionary principles ratified by the enactment of Section 22(b)(12), and the courts have, on occasion, continued to use the term solely in that context. See, e.g., Alice Phelan Sullivan Corp. v. United States, 381 F.2d 399, 401-402 (Ct. Cl. 1967). In recent years, however, the term has come to be used to encompass both the exclusionary principle and the inclusionary principle that it presupposes. See, e.g., Nash v. United States, 398 U.S. 1, 3 (1970); Home Mutual Insurance Co. v. Commissioner, 639 F.2d 333, 343 (7th Cir. 1980), cert. denied, 451 U.S. 1017 (1981); Anders v. United States, 462 F.2d 1147, 1149 (Ct. Cl.), cert. denied, 409 U.S. 1064 (1972); 1 B. Bittker, supra, Paragraph 5.7.1. It is in this broader sense that the term "tax benefit rule" is used in the present cases, which involve applications of the inclusionary aspect of the rule in different factual contexts. While neither Section 22(b)(12) nor its successor, Section 111 of the 1954 Code, expressly codified the "inclusionary" aspect of the rule, this enactment necessarily signals Congress' approval of the "inclusionary" principles applicable here. See Continental Illinois National Bank & Trust Co. v. Commissioner, 69 T.C. 357, 370 (1977); 1 B. Bittker, supra, Paragraph 5.7.1, at 5-49. /12/ 2. The inclusionary aspect of the tax benefit rule requires the restoration to income of a prior year's deduction when subsequent events establish the invalidity of the factual premise on which the prior year's deduction was claimed. What is at issue in the present cases is whether the application of the tax benefit rule depends upon the actual physical recovery of money or property by the taxpayer, or whether the rule also requires restoration to income of a previously deducted expense when subsequent events eliminate the factual premise on which the deduction was originally claimed. We submit that the latter proposition is the correct rule. In Hillsboro Bank, the pertinent event was the judicial determination that the previously deducted state tax was not due and owing and the refund of those tax payments to the Bank's shareholders. Likewise, in Bliss Dairy, the relevant event was the liquidation of the corporation and its distribution of unconsumed cattle feed to its shareholders, thereby establishing that the cattle feed would not be consumed in its business. If a state tax turns out not to be due, there is no basis for continued enjoyment of a deduction premised on its payment and the bank must restore the deduction to income. And if cattle feed will not be used in a corporation's business, that corporation must restore the deduction to its income when the fact of non-comsumption by the corporation becomes established. In sum, the subsequent events in both cases demonstrate that the taxpayers did not incur the expense for which they previously claimed the deductions. 3. Perhaps the most common application of the tax benefit rule arises in the context of the deduction for state income taxes permitted by Section 164 of the Code. Suppose A, a salaried employee who reports his income on the cash basis method of accounting, has $2,000 of state income taxes withheld from his salary during 1980. When he files his 1980 state income tax return on April 15, 1981, he discovers that his state tax liability is only $1,500, so that he is entitled to a $500 refund, which the state department of revenue pays to him in June 1981. As a cash basis taxpayer, A is entitled to claim the $2,000 in taxes as an itemized deduction on his 1980 federal return, since that amount was fully paid by withholding during 1980. However, because the deduction produced a tax benefit in 1980, A must include the $500 refund in his 1981 federal taxable income. Indeed, the frequency of this situation has led the Internal Revenue Service to add a line entitled "Refunds of state and local income taxes" (Line 9) on the Form 1040 individual income tax return so as to increase compliance with the tax benefit rule. The parties would apparently agree that the foregoing example offers an appropriate case for the application of the rule. They disagree, however, as to the critical element upon which the tax benefit rule rests. The taxpayers in these cases urge that the sine qua non for the application of the rule is the actual recovery of money or property, i.e., the receipt of the state tax refund. In Hillsboro Bank, the taxpayer asserts that the payment of the tax refunds to its shareholders (rather than to itself) renders the tax benefit rule inapplicable. In Bliss Dairy, the taxpayer claims that it never received any recovery warranting application of the rule. But surely the actual receipt of the tax refund is not the critical element necessary to support the application of the tax benefit rule. Returning to our example, if A had claimed the standard deduction in 1980 or had a tax loss for that year without taking the state tax deduction into account, his actual receipt of the $500 state tax refund would not have been includable in his 1981 gross income. Conversely, if A had claimed an itemized deduction for the state taxes and therefore enjoyed a tax benefit on his 1980 return, but the state required him to credit the $500 refund to his (or his wife's separate) 1981 state tax liability, the tax benefit rule would nevertheless require the inclusion of the $500 refund in his 1981 federal gross income. Properly analyzed, the $500 refund would have been deemed to have been paid to A, who then would be deemed to have paid it either back over to the state, or to his wife, who then would have been deemed to have paid it back to the state. In the same manner, Hillsboro Bank must be deemed to have received back the tax refund and paid it over to its shareholders. Hence, actual receipt or recovery of the money or property disbursed in connection with the prior year's deduction is not a requirement of the tax benefit rule. We submit that there are two essential elements for the application of the inclusionary aspect of the tax benefit rule at issue in these cases. First, the prior year's deduction must produce a tax savings or benefit. That element is indisputably present in both of these cases. Both Hillsboro Bank and Bliss Dairy enjoyed a tax benefit from their deductions of state taxes and cattle feed purchases. Second, an event must occur in the tax year at issue which eliminates the factual premise upon which the deduction was originally claimed. This event could well take the form of an actual recovery of money or property, as in the first variation of our example. The $500 tax refund to the taxpayer removes the factual premise upon which the $2,000 deduction for taxes was based and requires a corrective adjustment of $500 for the year that the refund was paid. But the event that removes the factual premise of the prior deduction (in part or in whole) need not take the form of an actual physical recovery of money or property. It could, as we suggest, take the form of a required issuance of a $500 credit to A's (or his wife's) 1981 state tax liability. The factual premise underlying the original deduction would nevertheless be refuted, requiring restoration of the prior year's deduction into income. There are many other instances in which the subsequent event that undermines the foundation of the prior year's deduction and triggers the application of the tax benefit rule does not involve any recovery at all. In our view, the triggering event can be any after-arising circumstance that demonstrates the invalidity of the factual premise on which the prior deduction was originally claimed. It is this so-called "inconsistent event" that lies at the heart of the tax benefit rule and requires a corrective adjustment to set matters right. If, for example, the events at issue here had occurred during the self-same prior year in which the deductions were taken, there is no doubt that neither Hillsboro Bank or Bliss Dairy would have been entitled to claim their deductions for state taxes and cattle feed. When such "inconsistent" events occur in a subsequent taxable year, they remove the factual premise of the prior year's deductions. The tax benefit rule thereby requires restoration of those deductions to income. B. The Courts Developed The Tax Benefit Rule In Order to Offset The Benefit Of A Deduction For Expenses Or Losses Which Subsequent Events Establish Will Not Be Incurred 1. The earliest origins of the principles underlying the tax benefit rule are found in the Treasury Regulations under the Revenue Act of 1913. Treasury Regulations 33, Art. 125(1914) required the inclusion in income of collection on debts for which bad debt deductions had previously been taken. That regulation itself assumed an actual receipt of the previously deducted amount. But such a recovery, standing alone, would not be includable in the taxpayer's gross income insofar as the repayment of a loan is not ordinarily "income" within the meaning of the Sixteenth Amendment or the taxing statute. See Alice Phelan Sullivan Corp. v. United States, supra, 831 F.2d at 401; 1 B. Bittker, supra, Paragraph 5.7.1 Rather, the recovery was simply an occasion for requiring a restoration to income of a previously deducted amount based on the fact that retention of the "tax benefit" generated by that deduction could no longer be justified. The early case law makes much the same point in extending the tax benefit rule to the repayment of any amount for which a tax loss had previously been claimed. For example, in South Dakota Concrete Products Co. v. Commissioner, 26 B.T.A. 1429 (1932), the Board of Tax Appeals applied tax benefit principles to the recovery of embezzled amounts for which a loss deduction had been taken in a prior year, explaining that the basic justification for the rule was the necessity of accurately reflecting the taxpayer's income over a multi-year period. As the Board stated (26 B.T.A. at 1431): "The Commissioner has added no more to income than has been deducted previously, thus bringing the amount of income reported over the period in balance with the actual income of the taxpayer for this period." The Board noted that the original deductions were simply "practical necessities due to our inability to read the future, and the inclusion of the recovery in income is necessary to offset the deduction" (id. at 1432). /13/ While the facts of South Dakota Concrete involved an actual recovery, the "balancing entry" theory adopted by the Board was not limited to the particular circumstances of that case. On the contrary, as the Board there indicated, the theory would apply whenever "an adjustment occurs which is inconsistent with what has been done in the past in the determination of tax liability" (26 B.T.A. at 1432). That such an "adjustment" might be required in a case involving other than an "actual recovery' is illustrated by the Board's subsequent decision in Barnett v. Commissioner, 39 B.T.A. 864 (1939). There, the Board upheld Treasury Regulations that required the taxpayer to restore to income a previously claimed depletion deduction taken in anticipation of exhaustion of her property's oil reserve when the lease she had granted to an oil company expired without any production ever having taken place. This Court subsequently reached the same result. /14/ The significance of Barnett and its progeny is that the Board relied on the tax benefit principle as authority for the Regulation. Thus, the Board reaffirmed its balancing entry theory advanced in South Dakota Concrete that the taxpayer had to recognize income in the current year not because she had actually received anything that might be characterized as income in the current year -- for she plainly had not -- but because income recognition was necessary to balance out the prior deduction that was allowed in anticipation of events that did not ultimately occur. As the Board noted (39 B.T.A. at 867) (emphasis added): (T)he present case is analogous to a number of others, where, with or without a supporting regulation, an adjustment has been made during the taxable year in which actually no income was received. * * * Income tax liability must be determined for annual periods on the basis of facts as they existed in each period. When some event occurs which is inconsistent with a deduction taken in a prior year, adjustment may have to be made by reporting a balancing item in income for the year in which the change occurs. Accord: G.M. Standifer Construction Corp. v. Commissioner, 30 B.T.A. 184 (1934), appeal dismissed, 78 F.2d 285 (9th Cir. 1935). /15/ These early cases demonstrate that the application of the evolving principles that were ultimately comprehended as part of a broader "tax benefit rule" did not turn upon the identification and taxation of economic benefits that could be considered as actual current income. Rather, the courts recognized that the tax benefit rule was a remedial device designed to insure that a taxpayer's income over a period encompassing several taxable years would be accurately reflected where subsequent events establish that no loss or expenses will actually be incurred. Simply put, the tax benefit rule is a mechanism for putting right the imbalance caused by a previously claimed deduction that subsequent events prove to have exceeded the expense or loss actually incurred. /16/ 2. To be sure, there have been more elaborate rationales suggested for the tax benefit rule. For example, in National Bank of Commerce v. Commissioner, 115 F.2d 875, 876-877 (9th Cir. 1940), the court suggested that the underlying theoretical basis of the tax benefit rule is that when a taxpayer takes a deduction, he is constructively recouping his capital investment, so that any further amounts received with respect to the deducted item lose their nature as returns of capital and take on, instead, the characteristics of the original income that had been offset by the deduction. /17/ In Philadelphia National Bank v. Rothensies, 43 F. Supp. 923, 925 (E.D. Pa. 1942), the court characterized the rule in terms of waiver or estoppel. As it explained, a taxpayer who has claimed a deduction is presumed to have consented to the recovery of the deduction should it later turn out that the deducted amount exceeded his actual cost or loss. See also Commissioner v. First State Bank, 168 F.2d 1004 (5th Cir.), cert. denied, 335 U.S. 867 (1948), where the court held that a bank that distributed notes to its shareholders, after having previously charged off the notes as worthless, was chargeable with additional income when the shareholders later made collections on the notes. While the majority opinion rested this result on assignment of income principles (168 F.2d at 1010), the concurring opinion of Judge Sibley (speaking for himself and two of the other five judges) further indicated that the bank had assumed both "the legal and the moral duty" to restore future recoveries to income when it claimed the deductions and that it could not free itself of that obligation simply by transferring the uncollected notes to its shareholders (168 F.2d at 1011). The common thread linking the judicial and scholarly theories addressing the basis of the tax benefit rule is that they all recognize that the "recovery" or other event triggering the application of the tax benefit rule does not, of itself, constitute taxable income in the current year. Rather, income is recognized in the current year only because events of the current year have demonstrated the invalidity of the assumptions underlying a previously claimed deduction that served to reduce taxable income for a prior year. As Professor Bittker states in his authoritative treatise: While divergent, these theories share the view that the recoveries do not constitute economic gain in the ordinary sense and that their inclusion in income is an anomaly requiring explanation. The premise, evidently, is that a creditor's collection of a just debt does not increase his net worth, even if he previously concluded that the debtor would never pay, and that a homeowner would not ordinarily think that partial refund of his local property tax, following recomputation of his liability in the light of hindsight, was an income-producing event. Thus, the taxpayers in these cases are treated as realizing income only because they deducted amounts that, it now appears, exceeded their actual loss or cost. 1 B. Bittker, supra, Paragraph 5.7.1, at 5-47 to 5-48 (emphasis added). Since the basis of the tax benefit rule is the need to correct the income distortion caused by a taxpayer's having claimed a deduction for an expense or loss which, in the light of hindsight, exceeded his actual expense or loss, it follows that the rule should apply on the occurrence of any event that refutes the correctness of the factual assumptions underlying a previously claimed deduction. An actual recovery of money or property is "simply the usual manifestation of an 'inconsistent event,'" Byrne, The Tax Benefit Rule as Applied to Corporate Liquidations and Contributions to Capital: Recent Developments, 56 Notre Dame Law. 215, 232 (1980) (emphasis added). It is not, however, the only type of inconsistent event that triggers the application of the rule. /18/ 3. Nash v. United States, 398 U.S. 1 (1970), upon which petitioner Hillsboro Bank relies (H. Br. 16-17), is not to the contrary. There, a partnership that had previously established a bad debt reserve and had taken the appropriate deductions for additions to that reserve, transferred all of its assets (including its accounts receivable) to a newly formed corporation in exchange for that corporation's stock, pursuant to Section 351 of the Code. The parties agreed that at the time of the transfer, the amount of the bad debt reserve was reasonable so that the value of the stock received upon the transfer was equal to the net value of the receivables. On these facts, the Court rejected the Commissioner's argument that the reserve should be restored to the partnership's income because it was no longer needed in its business. Rather, the Court held that the tax benefit rule did not require the partnership to restore the reserve to income because the partnership received no gain as a result of the transaction. As it observed, "(w) edo not, however, understand how there can be a 'recovery' of the benefit of the bad debt reserve when the receivables are transferred less the reserve. That merely perpetuates the status quo and does not tinker with it for any double benefit out of the bad debt reserve" (398 U.S. at 5; footnote omitted). The particularized circumstances of Nash do not cast doubt upon the "inconsistent event" formulation of the tax benefit rule to which we subscribe. The factual premises underlying the deductions that were taken by the partnership in establishing and maintaining the reserve were in no way contradicted by the partnership's transfer of those receivables to the corporation under Section 351. /19/ The transaction therefore was not an event that was inconsistent with the claim of those prior deductions. Since the partnership's basis in the receivables was identical to their fair market value at the time of the transfer and the corporation took that basis, there was neither gain to the partnership nor the potential for any double tax benefit. /20/ Here, on the other hand, as we shall point out in greater detail, the State's refund of the taxes previously deducted by petitioner Hillsboro Bank, and the distribution to Bliss Dairy's shareholders of cattle feed that had previously been "expensed" by that corporation, are events that establish the invalidity of, and are therefore inconsistent with, the factual assumptions on the basis of which Hillsboro and Bliss previously claimed their deductions. Hillsboro Bank obtained the benefit of a deduction for a "tax" liability that was not ultimately incurred; Bliss Dairy enjoyed an "expense" deduction for materials that were not ultimately used in its business and that, thus, remained available as valuable assets for sale or distribution to shareholders. Absent the application of the tax benefit rule requiring the restoration of deduction of taxes to Hillsboro Bank's income upon the refund of the taxes to its shareholders, the Bank would obtain the anomalous result of obtaining a deduction for a dividend distribution to its shareholders. Moreover, since the transferee-shareholders in Bliss Dairy took the feed from their corporation at a "stepped-up" basis, they were able to claim further deductions with respect to that same item when they used the feed in their individually owned business. Accordingly, unlike the situation in Nash, the application of the tax benefit rule in these cases forecloses an improper deduction for the payment of dividends and a double tax benefit for the same item of expense. Hence, "Nash simply does not stand for the proposition, for which it is cited by taxpayer, that the tax benefit rule only applies in the case of an actual physical, as opposed to 'fictional,' recovery of a previously deducted amount." Tennessee-Carolina Transportation, Inc. v. Commissioner, 582 F.2d 378, 383 (6th Cir. 1978), cert. denied, 440 U.S. 909 (1979). See also Rev. Rul. 78-278, 1978-2 Cum. Bull. 134; Byrne, The Tax Benefit Rule as Applied to Corporate Liquidations and Contributions to Capital: Recent Developments, supra, at 232-233. II THE PERSONAL PROPERTY TAXES PREVIOUSLY DEDUCTED BY HILLSBORO BANK SHOULD BE RESTORED TO INCOME WHEN THE AMOUNTS IT PAID INTO ESCROW WERE REFUNDED TO ITS SHAREHOLDERS ON WHOSE BEHALF THEY HAD BEEN DEPOSITED 1. Ordinarily, where a corporation satisfies an obligation owing by its shareholders, the corporation is not entitled to claim the benefit of a deduction with respect to the payment. If the corporation nevertheless discharges its shareholders' obligations, the effect is that of a dividend distribution so that the shareholders themselves are charged with the receipt of dividend income to the extent their own obligations are satisfied. See, e.g., Wall v. United States, 164 F.2d 462, 464 (4th Cir. 1947). Cf. Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729 (1929). As early as 1921, however, Congress enacted special provisions allowing corporations to claim deductions for the unreimbursed payment of personal property taxes imposed on a shareholder's interest in the corporation. Revenue Act of 1921, ch. 136, Section 234(a)(3), 42 Stat. 254. These special provisions, allowing the corporation (rather than the shareholder) to claim a deduction for such taxes, have been carried over into successive revenue statutes and are now incorporated in Section 164(e) of the 1954 Code. Under this Court's decision in United States v. Consolidated Edison Co., 366 U.S. 380 (1961), however, deductions for payments of contested liabilities (such as the personal property taxes paid by Hillsboro Bank) would have been required to be deferred, in the case of accrual basis taxpayers, until such time as the liability had been finally resolved. In response to that decision, Congress enacted Section 461(f) of the Code, which allows a deduction for contested liabilities where "the taxpayer transfers money or other property to provide for the satisfaction of the asserted liability" and the deduction would otherwise be allowable. In support of this proposed change, the Senate Committee Report indicated that "allowing the deduction of items in the year paid * * * more realistically matches these deductions up with the income to which they relate than would the postponement of the deduction, perhaps for several years, until the contest is settled." S. Rep. No. 830, 88th Cong., 2d Sess. 100 (1964). The Committee also explicitly indicated, however, its understanding that the tax benefit rule would operate to offset any deduction for an expense that proved not to have been incurred. It therefore stated that "(t)o the extent that deductions are allowed under this rule and then subsequently, as a result of the contest, the items were found not to be payable, adjustment can be made for this overstatement of the deduction by the inclusion of the overstatement in income in the year in which the amount of the liability is finally determined" (ibid.). Accordingly, Hillsboro Bank was unquestionably entitled, under Sections 164(e) and 461(f), to deduct the amounts placed in escrow for payment of the contested Illinois personal property taxes in the year that payment was made. See Treas. Reg. Section 1.461-2(c)(1) and (c)(2), Example (2) (26 C.F.R.). But once it was determined in the following year that the Illinois constitutional provision at issue in this Court's decision in Lehnhausen v. Lake Shore Auto Parts Co., 410 U.S. 356 (1973), was valid and that the personal property taxes paid on behalf of individual shareholders were not owing, a restoration to Hillsboro Bank's income of the previously deducted amount was required, despite the fortuitous fact that the refund was directed to the shareholders on whose behalf the tax had been paid rather than to the Bank itself. The refund of the amounts previously paid on behalf of the Bank's shareholders for satisfaction of the personal property tax liability that might ultimately have been determined to be owing undermines the factual premise upon which the Bank previously deducted such amounts pursuant to Sections 164(e) and 461(f) of the Code. As we have noted (page 31, supra), Congress specifically intended that any "overstatement of the deduction" would be restored to income in the event that the contested liability is "finally determined." S. Rep. No. 830, supra, at 100. That refund in this case was paid directly to the shareholders on whose behalf the amounts were deposited in the escrow account pursuant to Ill. Ann. Stat. ch. 120, Section 676.01 (Smith-Hurd Cum. Supp. 1981), rather than to the Bank alone, or to the Bank and its shareholders jointly, is not a sufficient basis for allowing the Bank to retain the benefit of its prior deduction. Regardless of who is ultimately entitled to receive the refunded amount, the determination of nonliability and the consequent tax refund (whether to the Bank or to its shareholders) are inconsistent with the allowance of a deduction to any party under Section 164. While amounts were deposited for satisfaction of an asserted liability and, as a result, properly deducted at that time, no tax liability was, in fact, ever incurred by the Bank or its shareholders. Instead, what ultimately occurred was that the corporate funds that were originally deposited by the Bank for this purpose were diverted, via the escrow deposit, to its shareholders. Indeed, as the court below recognized both in this case (H. Pet. App. A-8) and previously in the virtually identical situation in First Trust (614 F.2d at 1147), /21/ the ultimate result in each case was to transform the escrow deposit into a dividend from the Bank to its shareholders. For, absent the special treatment allowed under Section 164(e), the payment of these taxes on behalf of the shareholders would have been treated as a dividend in the first instance. But the justification under those provisions for avoiding dividend treatment at that time (see Treas. Reg. Section 1.164-7 (26 C.F.R.)) entirely disappeared when the taxes were determined not to be owing and the amounts previously paid on the shareholders' behalf were distributed to those same shareholders. Thus, unless the tax benefit rule applies to restore the erroneous deduction to Hillsboro Bank's income, the Bank will have obtained the benefit of a wholly improper tax deduction for what was in the end no more than a dividend distribution to its shareholders. The corrective tax benefit rule is designed to prevent such an anomaly. /22/ 2. The dissenting judge below argued that application of the tax benefit rule would unjustifiably result in taxation of both the Bank and its individual shareholders upon the amounts refunded to those individuals (H. Pet. App. A-14 to A-20). It is, however, settled beyond peradventure under federal tax law that corporate income taxable to the corporation is, upon distribution as dividends, taxed again at the shareholder level without a corresponding deduction to the corporation. As the Seventh Circuit earlier stated in First Trust (614 F.2d at 1147): But, of course, the distributed refunds were corporate dividends, taxable to the stockholders when received, but, nevertheless, nondeductible expenses to the Bank under our familiar system of "double taxation" at both the corporation and shareholder level. I.R.C. Sections 316, 301. Thus, unless the deduction previously taken is reversed (by taxing the amount of the refund), the Bank will, in effect, have benefited from a deduction taken for a nondeductible distribution. Nor is there any unfairness in this result. Hillsboro presumably knew, from the outset, that the taxes in question were being contested and would not be owing in the event the validity of Illinois constitutional provisions in issue was sustained by this Court. It was also presumably aware of the possibility that payments it had made on behalf of its shareholders would be refunded, in the event that liability were set aside, to the shareholders themselves. /23/ That liability, moreover, was solely that of the shareholders and not that of the Bank itself. While it was customary for Illinois banks to pay such taxes on behalf of their shareholders, the statute required only that the bank retain so much of any dividends that it might distribute to shareholders as would be necessary to pay the taxes levied against their shares. Ill Ann. Stat. ch. 120, Section 558 (Smith-Hurd 1970). See, e.g., People v. First National Bank, 33 Ill. 2d 457, 211 N.E.2d 713 (1965); People v. Oak Park Trust & Savings Bank, 351 Ill. 334, 184 N.E. 643 (1933); People v. Toluca State Bank, 327 Ill. 638, 159 N.E. 240 (1927). /24/ Having chosen to use corporate funds to satisfy the personal obligations of the shareholders, Hillsboro can hardly complain that dividend treatment is unwarranted when the funds themselves were paid over to those same shareholders. While a deduction was proper for the year 1972 based on the circumstances existing as of the end of that year, it was clear, by the next year, that the tax liability on which that deduction was based did not exist. Restoration to income of the amount that escaped tax in 1972 was thus no less appropriate in these circumstances than would be the case if the escrow payments had been returned directly to the Bank for its own determination as to whether such amounts should then be distributed to the shareholders or reinvested on their behalf. 3. Hillsboro rests virtually its entire argument on the premise that the tax benefit rule requires the receipt by the taxpayer of an actual economic benefit in the year in question. But, as we have pointed out (pages 21-30, supra), that is not the basis of the rule. Even where there is an actual recovery, there would be no occasion for charging the taxpayer, on that ground alone, with the realization of additional gross income. Rather, what is required is the restoration to taxable income of the taxpayer's prior income that escaped tax in earlier periods solely as a result of deductions that were proper when claimed, but which were based on anticipated losses or expenses that subsequent events establish will not be incurred. /25/ The fact that the liability for the Illinois personal property tax in question was not resolved until after the deduction was claimed in 1972 resulted, as the court below concluded (H. Pet. App. A-8), in a significant "windfall" to the Bank in the form of avoiding federal income tax liability on the income offset by that deduction. Had Section 461(f) not been enacted, such contested liabilities would not have been deductible in the first instance. That statute enabled the Bank to claim a deduction in 1972. At the same time, the Bank's claim of a deduction for a contested liability necessarily gave rise to the possibility that the income that thereby escaped taxation would have to be restored in the later period in which the disputed liability was finally resolved. What is more, the application of the tax benefit rule in these circumstances is not -- as Hillsboro would have it (H. Br. 19-20) -- dependent upon either assignment-of-income or constructive receipt theories. The judicial development of the tax benefit rule shows that it arises from the need to offset the distortion resulting from the taking of a deduction of an anticipated expense or loss that is not ultimately incurred. The motives, perceptions and conduct of the taxpayer involved are irrelevant. Accordingly, Hillsboro's arguments (H. Br. 21-22) that it did not engage in collusion with the County Treasurer's office regarding the recipients of the tax refunds in no way affects application of the tax benefit rule. Finally, even if some form of recovery is deemed to be necessary to invoke the tax benefit rule, we submit that the Bank should be deemed to have at least constructively recovered the refunded taxes. Indeed, that is precisely what the Tax Court determined in this case. It stated that "When in 1973 (Section 164(e)) was retroactively determined not to apply, and the taxes paid were refunded to these same shareholders, (the Bank) must be deemed to have received back its payments from the state and itself paid these amounts out to its shareholders" (H. Pet. App. A-39). III THE AMOUNTS PREVIOUSLY DEDUCTED BY BLISS DAIRY THAT ARE ATTRIBUTABLE TO CATTLE FEED UNCONSUMED IN ITS BUSINESS AND DISTRIBUTED TO ITS SHAREHOLDERS ON LIQUIDATION SHOULD BE RESTORED TO ITS TAXABLE INCOME FOR ITS YEAR OF LIQUIDATION A. A Corporation's Distribution Of Previously Deducted Cattle Feed To Its Shareholders Refutes The Assumptions Underlying The Corporation's Claim To Deductions For The Cost Of That Feed 1. On its return for the taxable year ending June 30, 1973, respondent Bliss Dairy deducted the full cost of the $150,199 worth of cattle feed that it had purchased in that year. This deduction was based on the assumption that, even though income might be more accurately reflected through the use of inventory accounting for such supplies, the feed would ordinarily be consumed within a relatively short time in the course of the taxpayer's operation of the business. See Spitalny v. United States, 430 F.2d 195, 197 (9th Cir. 1970); Rev. Rul. 79-229, 1979-2 Cum. Bull. 210. Cf. United States v. Catto, 384 U.S. 102 (1966). However, only $93,634 of the feed was consumed in the year for which the deduction was claimed. On the second day of the next taxable year, Bliss adopted a plan of liquidation and, within the month, distributed the remaining $56,565 worth of previously expensed feed to its shareholders. This in kind of distribution of unconsumed feed eliminated the basis for the original assumption underlying Bliss' deduction that the feed would be consumed in the ordinary course of Bliss' business. If Bliss Dairy had permitted the feed to be used for the personally-owned cattle of its shareholders there would be no question that its deduction for that feed would have to be restored to income. Accordingly, Bliss' liquidating transfer of the feed was likewise an appropriate event for applying the tax benefit rule so as to require a restoration of the amount deducted in the prior year for the distributed feed. /26/ There are, to be sure, instances in which a transfer of previously "expensed" property would not be inconsistent with the deduction and in which the restoration to income of the previously deducted amount would not be warranted. For example, where property is transferred to a successor corporation pursuant to a corporate reorganization within the scope of Section 368(a)(1) of the Code or to a parent corporation on the liquidation of a subsidiary under Section 332 of the Code (other than a liquidation to which Section 334(b)(2) applies), the property remains in corporate solution and the transaction is generally treated, for federal income tax purposes, as "work(ing) a change of form rather than of substance." B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders Paragraph 11.40, at 11-31; Paragraph 14.01, at 14-6 (4th ed. 1979). In either of these cases, the transferee corporation takes the property subject to the same basis that it had in the hands of the transferor -- zero, of course, in the case of property that had already been fully "expensed" at the time of the transfer. See Sections 334(b)(1) and 362(b). See also B. Bittker & J. Eustice, supra, Paragraph 11.44, at 11-41 and 11-42; Paragraph 14.33, at 14-108 and 14-109. For example, if the unconsumed cattle feed had been transferred to a parent corporation or to a successor corporation in a qualifying reorganization, its zero basis would have carried over to the transferee and no further deduction would have been taken. /27/ In these special circumstances, the transferee is deemed to have stepped into the shoes of the transferor. A substantially different situation is presented, however, when fully "expensed" property is transferred out of corporate solution, as in the instant case, or to another corporation in a transaction that is not treated, for tax purposes, as simply working a change of form. See Tennessee-Carolina Transportation, Inc. v. Commissioner, supra. In these cases, the zero (or other) basis of the property in the hands of the transferor does not carry over to the transferee in such instances. For example, where the stock of a liquidating corporation is acquired by a corporation pursuant to a transaction qualifying under Section 334(b)(2) of the Code, the transferee is treated as a purchaser of the underlying assets and is accordingly entitled to allocate the cost of acquiring the stock among all the assets acquired (including previously "expensed" items). See e.g., Kimbell-Diamond Milling Co. v Commissioner, 14 T.C. 74 (1950), aff'd, 187 F.2d 718 (5th Cir.), cert. denied, 342 U.S. 827 (1951); Kansas Sand & Concrete, Inc. v. Commissioner, 462 F.2d 805 (10th Cir. 1972); In re Chrome Plate, 614 F.2d 990 (5th Cir. 1980). B. Bittker & J. Eustice, supra, Paragraph 11.44, at 11-42 through 11-48. Other shareholders who receive in-kind liquidating distributions ordinarily take the property at a basis equal to its fair market value on the date of distribution. Section 334(a); B. Bittker & J. Eustice, supra, Paragraph 11.04. Finally, where, as here, a corporation is liquidated pursuant to the elective provisions of Section 333, /28/ the shareholder's basis in his stock (reduced by any money received and increased by any gain recognized on the transaction) is likewise allocated among the assets acquired in accordance with their relative fair market values. Section 334(c) of the Code; Treas. Req. Section 1.334.2 (26 C.F.R.). See generally B. Bittker & J. Eustice, supra, Paragraph 11.22. Although the basis of distributed assets may vary depending on whether Section 334(a), 334(b)(2) or 334(c) applies, in each instance the "expensed" items do not retain the "zero" basis they had in the hands of the transferor, but acquire an appropriately "stepped-up" /29/ basis in the hands of the transferees enabling them, as in Bliss Dairy, to claim a further deduction when the items are actually consumed in the course of their separate businesses, or to avoid the recognition of gain in the event they choose to sell the previously expensed materials to third parties. Thus, the result in cases involving liquidations, such as Bliss Dairy, is not simply to shift income temporarily from one period to another, but to leave the transferor (unless the tax benefit rule is applied) with the permanent "tax benefit" of an "expense" deduction for the cost of items that were not, in fact, consumed, and never will be consumed, in its own trade or business. Moreover, shareholders will be able to claim a further deduction for the same item. As this Court has admonished, " * * * the Code should not be interpreted to allow * * * 'the practical equivalent of double deduction'; Charles Ilfeld Co. v. Hernandez, 292 U.S. 62, 68 (1934), absent a clear declaration of intent by Congress." United States v. Skelly Oil Co., supra, 394 U.S. at 684. See also Marwais Steel Co. v. Commissioner, 354 F.2d 997 (9th Cir. 1965). Indeed, the case for the application of the tax benefit rule is considerably strengthened by the fact that the facts present not simply the "practical equivalent" of a double deduction but an actual potential double deduction. Here, the shareholders of Bliss Dairy, who continued the dairy business in non-corporate form, took a "stepped-up" basis /30/ in the cattle feed, and quite properly deducted the amount of that basis when the feed was consumed in the course of their business. In a prior year, Bliss Dairy claimed a similar deduction. In these circumstances, the corporation must restore to its own income that portion of the amount previously deducted that was attributable to the feed that was not ultimately used in its trade or business and that remained available for sale or distribution to shareholders on the winding up of the corporation's affairs. /31/ 2. In holding that Bliss Dairy's tax benefit from its deduction for cattle feed for use in its business and its subsequent distribution to its shareholders of that feed did not require restoration of the deduction to the corporation's income unless there was an actual recovery by the corporation of money or additional property, the court below relied exclusively on its prior decision in Commissioner v. South Lake Farms, Inc., supra. It quoted the following statement from South Lake Farms (B. Pet. App. 4a): "Nowhere in the Code do we find an intent that gains to the stockholders were to be attributed to the corporation, much less that they were to be treated as ordinary income to the corporation" (324 F.2d at 839). /32/ The court below thus misunderstood why Bliss Dairy should be required to recognize income in the current taxable year. The government is not seeking to attribute to Bliss the gains of its shareholders. Rather, it is Bliss' own ordinary income -- the income that escaped tax in a prior taxable year as a result of the deduction for cattle feed that would be consumed, if at all, only in subsequent periods -- that the government seeks to restore to taxable income. Once subsequent events made it clear that the anticipated events on which the deduction was based -- that the feed would shortly be used (and, thus, become an "expense") in the operation of the corporate business -- would never occur, such a restoration to income is required under the tax benefit rule. Indeed, as the Ninth Circuit itself recognized in a case decided subsequently to Bliss Dairy, the recovery of a deduction is taxed under the tax benefit rule "because it previously created a tax benefit, not because of the inherent characteristic of the recovery." Unvert v. Commissioner, 656 F.2d 483, 486 (9th Cir. 1981), cert. denied, No. 81-1467 (May 2, 1982). Here, where Bliss Dairy indisputably took a deduction that offset its ordinary income, and where that deduction was in an amount that, as subsequent events showed, exceeded its actual cost of doing business, the restoration of that deduction to income in its final taxable period was necessary to offset the deduction that proved to be excessive. It is that necessity that gave rise to the tax benefit rule, and calls for its application in this case. B. At All Events, Even If An "Actual Recovery" Is Required For The Application Of The Tax Benefit Rule, Bliss Dairy Enjoyed Such A Recovery Even if the tax benefit rule requires an actual recovery to trigger its application, Bliss Dairy did enjoy the benefits of such a recovery in this case. As the Sixth Circuit noted in Tennessee-Carolina Transportation, Inc. v. Commissioner, supra, 582 F.2d at 382, where the cost of materials and supplies are "expensed," they are "in contemplation of the tax laws, completely consumed." This deduction is allowed and a zero basis assigned not because there has been an actual loss or exhaustion of value, but on the "contemplation of their actual consumption." As a result, they are treated, for tax purposes, as having become a "nonentity" (ibid.). Where, however, the corporation's own activities are wound up before such actual consumption takes place, the value of the property remains available to the corporation and its shareholders, to be enjoyed either by the sale of the property by the corporation or by distribution of the unconsumed property to the shareholders for their own sale or use. In either case, there is a "recovery" of the value that had been "fictionally" converted into an item of expense. Such a "fictional conversion" must, of course, be hypothesized to allow a current "expense" deduction because an expenditure for the acquisition of valuable assets "is capital in nature and not an expense, let alone an ordinary expense * * * ." Commissioner v. Lincoln Savings & Loan Association, 403 U.S. 345, 354 (1971). The allowance of a current expense deduction for items that will ordinarily not be consumed within a short period is based on practical considerations. Those same practical considerations mandate that what is deemed to have been consumed in the year of acquisition should be deemed recovered, as the Sixth Circuit concluded in Tennessee-Carolina, when it is transferred from a corporation to another party. Indeed, the Ninth Circuit itself recognized in Spitalny v. United States, supra, 430 F.2d at 198, that there has been, in such circumstances, a "fictional conversion of * * * 'property' into a consumed item of expense" and that (ibid.) -- "(i)f the feed and supplies are to revert to 'property' they should be reconverted. They should not at the same time be property and still retain attributes of a fictional nonentity." See also Anders v. United States, supra, 462 F.2d at 1149. In Spitalny, the liquidating corporation sold the previously expensed, but unconsumed, cattle feed and other expensed supplies there in question, and distributed the proceeds to the shareholders. Accord: Tennessee-Carolina Transportation, Inc. v. Commissioner, supra, 582 F.2d at 382. As an economic matter, the parties are in precisely the same position whether such expensed property is sold by the corporation or distributed "in kind" to the shareholders. If a restoration to income of the previously deducted amount is in order in the first instance (as virtually every court that has considered the matter has concluded -- see page 42, note 31, supra), such a restoration is likewise appropriate here. There is a second basis for attributing a "recovery" to the liquidating corporation -- assuming such a "recovery" is essential. The liquidation of a corporation is itself an "exchange" of property -- i.e., a transfer by the shareholders of their shares to the corporation, in exchange for a distribution by the corporation of its assets. See B. Bittker & J. Eustice, supra, Paragraph 11.01. While it is true that after the liquidation has been completed the shares received by the corporation loses its value, such stock presumably had the same value as the distributed assets themselves had at the time of the transaction. Tennessee-Carolina Transportation, Inc. v. Commissioner, supra, 582 F.2d at 382. Accordingly, at the time Bliss Dairy received its shares back from its shareholders in the course of the liquidation, that stock still had value reflecting, inter alia, the $56,565 in unconsumed cattle feed remaining on hand. /33/ Thus, under the facts of this case, there was a "recovery" of the value of the unconsumed cattle feed. While it is true that the recovery was transient, it was no less transient than the recovery would be on a liquidation sale, as in Spitalny, where the proceeds are immediately distributed to the shareholders in the course of liquidation. Ordinarily, the receipt of stock by the corporation in exchange for the distribution of its assets on liquidation is not treated as a taxable transaction to the corporation. Section 336 provides that "no gain or loss shall be recognized to a corporation on the distribution of property in partial or complete liquidation." See B. Bittker & J. Eustice, supra, Paragraph 11.61. Thus, the value of appreciated property distributed in kind to the shareholders is not treated as having been realized by the corporation. See United States v. Cumberland Public Service Co., 338 U.S. 451 (1950). But the provisions of Section 336 should not be considered as having any greater bearing on the application of the tax benefit rule in this context than the analogous provisions of Section 337(a) of the Code, providing that "no gain or loss shall be recognized to * * * (the) corporation from the sale or exchange by it of property" pursuant to a 12-month liquidation plan qualifying under that Section. As we have pointed out (page 42, note 31, supra), the courts have uniformly upheld the Commissioner's position in requiring the restoration of prior deductions to income where previously expensed items are sold pursuant to such Section 337 liquidations, despite the "no gain or loss" language of that statute. Those cases simply reflect the established understanding of the function of the tax benefit rule as requiring a restoration to income of a previously deducted amount, even though there would be no occasion for charging the taxpayer with additional income, absent the enjoyment of such a prior tax benefit. To construe Section 336 as precluding the application of the tax benefit rule to a corporation that distributes previously expensed property to its shareholders, notwithstanding its "recovery" of stock having an equivalent value, would result in a wholly unjustified disparity in the tax treatment of liquidations falling within Section 337 (where property is sold and the proceeds are distributed to the shareholders) and liquidation distributions of property governed by Section 336. Indeed, it was the purpose of Section 337 to eliminate such tax disparities based on whether property was sold by a liquidating corporation (as in Commissioner v. Court holding Co., 324 U.S. 331 (1945)) or distributed to the shareholders (as in United States v. Cumberland Public Service Co., supra). See H.R. Rep. No. 1337, 83d Cong., 2d Sess. A 106 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 258-259 (1954). /34/ Assume, for example, that a liquidating corporation is in possession of $100,000 of previously expensed supplies. It may choose either (1) to sell such property for that amount and to distribute the proceeds, or (2) to distribute the property directly to the shareholders. Those shareholders, in turn, might then sell the property for the same amount or obtain the economically equivalent benefit of using the property in their own trade or business, claiming a "stepped-up" basis of the property (which will, as noted above, ordinarily equal or approach its fair market value) so as to generate further deductions from their own income. In either case, the economic positions of the parties are the same. There is accordingly no justification for treating the transactions differently, particularly in light of the purpose of Section 337 to eliminate disparities in the tax treatment of such transactions. "(F) rom a tax policy standpoint it does not make sense that in applying a judicially created rule intended to avoid income distortions, results should differ depending on whether a corporation liquidates by way of Section 336 or 337." Byrne, The Tax Benefit Rule as Applied to Corporate Liquidations and Contributions to Capital: Recent Developments, supra, 56 Notre Dame Law, at 232. The courts are agreed that there is no reason why the corporation should not be required to restore the previously deducted amount to income when it sells the property and distributes the proceeds pursuant to Section 337. Yet, pursuant to the decision of the court of appeals in the instant case under Section 336, nothing is restored to income, and the tax savings resulting from the prior deduction are passed on to the shareholders despite the fact that the fully "expensed" property is distributed to them with a stepped-up basis. This is just the type of disparity that Congress intended to end when it enacted Section 337 as part of the Internal Revenue Code of 1954. If that intent is to be fully effectuated, liquidations under both Sections 336 and 337 should be treated alike. See Midland-Ross Corp. v. United States, 485 F.2d 110, 114 (6th Cir. 1973); B. Bittker & J. Eustice, supra, Paragraph 11.65. Otherwise, the course set by the court below will "elevate form over substance by reviving technical differentiations put to rest in 1954 with the adoption of Section 337." Tennessee-Carolina Transportation, Inc. v. Commissioners, supra, 582 F.2d at 383 (footnote omitted). /35/ CONCLUSION The judgment of the court of appeals in No. 81-485 should be affirmed. The judgment of the court of appeals in No. 81-930 should be reversed. Respectfully submitted. REX E. LEE Solicitor General GLENN L. ARCHER, JR. Assistant Attorney General STUART A. SMITH Assistant to the Solicitor General GARY R. ALLEN JAY W. MILLER DAVID I. PINCUS Attorneys MAY 1982 /1/ "H. Pet. App." references are to the appendix to the petition in the Hillsboro National Bank case, and "B. Pet. App." references are to the appendix to the petition in the Bliss Dairy case. Pursuant to the Court's order of March 1, 1982, no joint appendix has been filed in these cases. /2/ Section 164(e) provides that where a corporation pays a tax imposed on a shareholder on his interest as a shareholder and is not reimbursed for such payment, the corporation (and not the shareholder) is allowed the deduction for the tax provided for by Section 164(a). Such payment is not then included in the shareholder's gross income. Treas. Reg. Section 1.164-7 (26 C.F.R.). /3/ Under Section 333, shareholders receiving corporate assets pursuant to a qualifying one-month liquidation are required to recognize only so much of their gain as does not exceed the greater of their pro rata share of the corporation's earnings and profits or the amount of money and (post-1953) stock and securities received in the liquidation. /4/ Under Section 334(c) of the Code, a shareholder's basis in property acquired in a Section 333 liquidation is equal to the basis he had in the liquidating corporation's stock, decreased by the amount of money received in the liquidation, and increased by the amount of any gain recognized. Where several assets are received, the shareholder apportions his total basis among these assets in accordance with their relative fair market values. Treas. Reg. Section 1.334-2 (26 C.F.R.). The record does not disclose the exact amount of basis that the Bliss shareholders assigned to the unused cattle feed distributed by the corporation. However, the parties stipulated in the district court that the shareholders, on their 1973 individual income tax returns, claimed deductions attributable to the feed they received in the liquidation (see B. Pet. App. 3a). /5/ It was later stipulated that at the time of distribution, the unconsumed feed had a value of $56,565 (B. Pet. App. 3a). /6/ See Tennessee-Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440 (1975), aff'd, 582 F.2d 378 (6th Cir. 1978), cert. denied, 440 U.S. 909 (1979); First Trust and Savings Bank v. United States, 614 F.2d 1142 (7th Cir. 1980); Hillsboro National Bank v. Commissioner, 641 F.2d 529 (7th Cir. 1981), cert. granted, No. 81-485 (Jan. 18, 1982). /7/ This Court subsequently reached the same result in Douglas v. Commissioner, 322 U.S. 275, 284-287 (1944). /8/ Moreover, even if some form of recovery is deemed to be necessary to invoke the tax benefit rule, we submit that the Bank constructively recovered the refunded taxes. Indeed, that is precisely what the Tax Court determined in this case, stating that "When in 1973 (Section 164(e)) was retroactively determined not to apply, and the taxes paid were refunded to these same shareholders, (the Bank) must be deemed to have received back its payments from the State and itself paid these amounts out to its shareholders" (H. Pet. App. A-39). /9/ At all events, even on the assumption that an "actual recovery" is required to support an application of the tax benefit rule, Bliss Dairy had all the benefits of such a recovery from its distribution of the unconsumed cattle feed to its shareholders. For tax purposes, once the cost of materials are deducted, they are regarded as completely consumed. They are assigned a zero basis and are actually treated nonexistent for tax purposes. When, however, the value of the property becomes available for distribution to shareholders for their own sale or use, there is a "recovery" for tax purposes of the value that had been previously converted into an item of expense. Second, Bliss Dairy's receipt of its stock certificates from its shareholders in the course of its liquidation constituted a recovery of the unconsumed cattle feed. At the time Bliss Dairy received its shares back from its shareholders in the course of liquidation, those shares still had value reflecting the $56,565 in unconsumed cattle feed remaining on hand. Thus, there was a "recovery" of the value of that feed. Thus, an actual recovery occurred when Bliss Dairy exchanged its assets for shares that had an equivalent value at the time of the transfer. /10/ In United States v. Lewis, supra, the allowance of a later-year deduction for the repayment of previously reported income did not produce a tax benefit commensurate with the tax cost of reporting the item of income in the first instance. In response, Congress added Section 1341 to the statute, as part of the 1954 codification, in order to achieve a closer correspondence between the tax benefit of the later deduction and the tax cost of the earlier inclusion. Section 1341 generally provides that if an item is included in income under a claim of right in one year and becomes deductible in a subsequent year because it was established that the taxpayer did not have an unrestricted right to the item, and the amount of the deduction exceeds $3,000, then the tax for the subsequent year is the lesser of: (a) the tax computed with the deduction; or (b) the tax for the taxable year computed without the deduction, minus the decrease in tax for the prior taxable year that would result from the exclusion of the item from gross income for the prior taxable year. The statute therefore insures that the tax benefit obtained will be the greater of the amount achieved either by deduction or exclusion. /11/ Section 111 thus performs a function that is somewhat analogous (albeit with somewhat less precision) to Section 1341 in the context of the "claim of right" doctrine (see page 15, note 10). In United States v. Skelly Oil Co., supra, where the special provisions of Section 1341(a)(5) did not apply, the Court adopted an analogue to this aspect of the tax benefit rule, holding that where the taxpayer had enjoyed the benefit of a depletion allowance measured by a percentage of previously reported income which it was thereafter required to give up, the amount of the subsequent deduction under North American Oil should be similarly reduced. In so holding the Court noted that the taxpayer would otherwise be allowed "'the practical equivalent of a double deduction,'" a result the Court concluded should not be permitted "absent a clear declaration of intent by Congress" (394 U.S. at 684, quoting Charles Ilfeld Co. v. Hernandez, 292 U.S. 62, 68 (1934)). /12/ Congress' approval of the "inclusionary" aspect of the tax benefit rule is also implied by its enactment of Section 461(f) of the Code, allowing the deduction of contested liabilities. As we discuss (pages 31-32, infra), Congress enacted this provision on the explicit understanding that a restoration to income would be required if the liability was ultimately set aside. See S. Rep. No. 830, 88th Cong., 2d Sess. 100 (1964). /13/ Cf. Home Mutual Insurance Co. v. Commissioner, 639 F.2d 333, 344 (7th Cir. 1980), cert. denied, 451 U.S. 1017 (1981) (explaining that the tax benefit rule "allows accurate taxation of a whole transaction that may span several accounting periods," and permits "adjustments so that some transactions substantially altered in years subsequent to the original accounting period may be taxed virtually as though the entire transaction had occurred in one period"). /14/ The requirement that oil depletion deductions be restored once it is clear that no mineral production will actually take place was approved in Sneed v. Commissioner, 119 F.2d 767 (5th Cir), cert. denied, 314 U.S. 686 (1941), in Lamont v. Commissioner, 120 F.2d 996 (8th Cir. 1941), and, ultimately, in Douglas v. Commissioner, 322 U.S. 275, 284-287 (1944), which cited all three prior decisions with approval. As the Eighth Circuit noted in Lamont, such a restoration does not "arbitrarily assume non-existent income" (120 F.2d at 997). What is ultimately subjected to tax, as the court there emphasized, is the real income that escaped tax when the original depletion allowance was claimed. Cf. United States v. Skelly Oil Co., supra, 394 U.S. at 684, which similarly required corrective adjustment where the income, on which a depletion allowance was previously claimed, was required to be refunded. /15/ There, the Board required the taxpayer, in the year of its liquidation, to restore to income the amount of prior accrued deductions for wages that remained unpaid at that time. In holding that prior deductions for what amounted to a "reserve" for unpaid liabilities on a disputed claim should also have been restored to income, but only in the prior year when the dispute was settled for a lesser amount, the Board noted that "(t)he theory underlying the restoration of reserve balances to income, like that of recoveries on losses for prior years * * * and collections on debts previously deducted as worthless * * * , is that by taking the deductions in the earlier years the taxpayer benefited through a reduction of its taxable income, and subsequent events demonstrate that there was in fact no loss, even though honest belief so indicated at the time" (78 F.2d at 187). /16/ Legal scholars and commentators likewise agree that the purpose of the tax benefit rule is to rectify the distortion caused by a taxpayer's having taken a deduction to which, in the light of hindsight, he would not be entitled. See, e.g., Plumb, The Tax Benefit Rule Today, 57 Harv. L. Rev. 129, 176 (1943) ("The rule requiring taxation of income from the recovery or cancellation of items previously deducted is a remedial expedient, designed to prevent the unjust enrichment of a taxpayer and to offset the benefit derived from a deduction to which, in the light of subsequent events, the taxpayer was not entitled"); Byrne, The Tax Benefit Rule as Applied to Corporate Liquidations and Contributions to Capital: Recent Developments, 56 Notre Dame Law. 215, 232 (1980) ("The tax benefit rule has been designed by the courts as a tool for correcting the distortion resulting from a taxpayer's taking a deduction which, in the light of subsequent events, exceeds his loss or cost"). See also Lyon & Eustice, Assignment of Income: Fruit and Tree as Irrigated by the P.G. Lake Case, 17 Tax L. Rev. 295, 411 (1962). /17/ The court in National Bank of Commerce appears to have adopted this theory of "transubstantiation of capital into income" (1 B. Bittker, supra, Paragraph 5.7.1, at 5-46) in order to avoid what it perceived as the problem of imposing a tax in the absence of the realization of "income." We would suggest, however, that the constitutional implications of the tax benefit rule are not as formidable as the court believed. Nothing in the Sixteenth Amendment itself would require such a rigid adherence to an annual accounting concept as to preclude the making of adjustments in later periods under the "balancing entry" theory articulated in South Dakota Concrete whether or not any "income" as such has been received in the year of the adjustment. As this Court noted in United States v. Skelly Oil Co., supra, 394 U.S. at 684, "the annual accounting concept does not require us to close our eyes to what happened in prior years." At all events, as the Eighth Circuit noted in Lamont v. Commissioner, supra, the tax is imposed not on fictional income but on the restoration to taxable income of the real gains that escaped taxation in the first instance as a result of the prior deduction. /18/ Petitioner Hillsboro Bank complains (Br. 10-11) that the "inconsistent event" formulation of the tax benefit rule articulated in Estate of Block v. Commissioner, 39 B.T.A. 338, 341 (1939), aff'd, 111 F.2d 60 (7th Cir.), cert. denied, 311 U.S. 658 (1940) -- is broader than was required by the facts of that case which involved an actual recovery. Under that formulation, "(w)hen recovery or some other event which is inconsistent with what has been done in the past occurs, (then) adjustment must be made in reporting income for the year in which the change occurs." Tennessee-Carolina Transportation, Inc. v. Commissioner, 582 F.2d 378, 382 (6th Cir. 1978), cert. denied, 440 U.S. 909 (1979); First Trust & Savings Bank v. United States, 614 F.2d 1142, 1145 (7th Cir. 1980). Accord: Rosen v. Commissioner, 611 F.2d 942, 944 (1st Cir. 1980); Unvert v. Commissioner, 656 F.2d 483, 485 (9th Cir. 1981), cert. denied, No. 81-1467 (May 3, 1982). See also Bonaire Development Co. v. Commissioner, 76 T.C. 789, 797-801 (1981), appeal pending, No. 81-7469 (9th Cir.). But the "inconsistent event" formulation is an authoritative synthesis of the tax benefit rule, as applied in the early cases. It encompasses the cases involving actual recoveries (such as South Dakota Concrete and Estate of Block), cases involving what might be characterized, at best, as "constructive" recoveries (such as G.M. Standifer Construction Corp. v. Commissioner, supra), as well as cases such as Barnett v. Commissioner, supra, and its progeny, in which no recovery, either actual or constructive, could be attributed to the taxpayer. See also, e.g., Mayfair Minerals, Inc. v. Commissioner, 456 F.2d 622 (5th Cir. 1972); Bear Manufacturing Co. v. United States, 430 F.2d 152 (7th Cir. 1970), cert. denied, 400 U.S. 1021 (1971); Lime Cola Co. v. Commissioner, 22 T.C. 593, 601-602 (1954); Chicago, R.I. & P. Ry. v. Commissioner, 13 B.T.A. 988, 1022-1023 (1928), aff'd, 47 F.2d 990, 992 (7th Cir.), cert. denied, 284 U.S. 618 (1931), where, as in G.M. Standifer Construction Corp., the tax benefit rule was applied to require taxpayers to include in income the amount of liabilities that had been accrued and deducted but never paid. /19/ Pursuant to Section 362(a) of the Code, the corporation was required to take the partnership's basis in the receivables (face amount less the reserve). Hence, the corporation would have had to take into income any collections in excess of its basis in the receivables, just as the partnership would have been required to do. /20/ As Rev. Rul. 78-278, Rev. Rul. 78-279 and Rev. Rul. 78-280, 1978-2 Cum. Bull. 134, 136 and 139, point out, the decision in Nash would not necessarily preclude the application of the tax benefit rule with respect to bad debt reserves where a subsidiary distributes its assets to its parent pursuant to a liquidation under which the assets acquire a new basis pursuant to Section 334(b)(2) of the Code. For example, where accounts receivable had a value greater than the face value of such accounts less the bad debt reserve and where the transferee acquired the account subject to a basis equal to that greater amount, the transferor would be required, under those rulings, to restore to income the excessive additions to its bad debt reserve. In such circumstances, of course, the transferee, having acquired a new basis for the receivables, would be permitted to collect the full net value of the transferred accounts without realizing additional income, and would be entitled to claim further loss deductions in the event any lesser amounts were ultimately recovered. See also Home Savings & Loan Association v. United States, 514 F.2d 1199, 1200-1201 (9th Cir. 1975), cert. denied, 423 U.S. 1015 (1975), requiring the restoration of a previously deducted bad debt reserve to income on such a liquidation governed by Sections 332 and 334(b)(2). /21/ The refund checks in First Trust were made out jointly to the bank and its shareholders, while in Hillsboro they were issued directly to the shareholders. That, however, is a distinction without a difference since the Appellate Court of Illinois in Lincoln National Bank v. Cullerton, 18 Ill. App. 3d 953, 958-959, 310 N.E.2d 845, 848-849 (1974), ruled that, pursuant to Ill. Ann. Stat. ch. 120, Sections 676.01 (Smith-Hurd Cum. Supp. 1981), the amounts deposited in the escrow account belonged to the individual shareholders, not to the banks that made the deposits. See also Bank & Trust Co. v. Cullerton, 25 Ill. App. 3d 721, 324 N.E.2d 29 (1975). Accordingly, the bank in First Trust was obligated, as noted by the court of appeals in Hillsboro (H. Pet. App. A-6), to endorse over those refund checks to its individual shareholders. /22/ Hillsboro contends (H. Br. 21) that it cannot be found to have distributed dividends unless they have been declared as such by its board of directors. It is well settled, however, that for federal tax purposes, dividend distributions may take man forms, and need not be formally declared or even intended. See, e.g., Baumer v. United States, 580 F.2d 863, 876 (5th Cir. 1978); Honigman v. Commissioner, 466 F.2d 69, 73 (6th Cir. 1972). See also Commissioner v. Gordon, 391 U.S. 83, 89-91 (1968). See generally B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders Paragraph 7.05, at 7-27, 7-28 (4th ed. 1979). /23/ While the provisions of Ill. Ann. Stat. ch. 120, Section 676.01 (Smith-Hurd Cum. Supp. 1981), providing that "(e)ach taxpayer for whom such tax payments are placed in escrow shall be eligible for automatic full repayment from the county collector if such personal property taxes are ultimately held to be invalid" was not finally approved until July 27, 1972, some 21 days after the amounts in question were paid, the bill itself had passed in the Illinois General Assembly on June 29, 1972. See 1972 Ill. Laws, Pub. Act 77-2133. /24/ If the Bank had simply withheld from dividends an amount sufficient to pay the taxes, the shareholders would presumably have been entitled to claim the deduction themselves under Section 164(a)(2). The Bank then would not have been entitled to claim a deduction under Section 164(e). See Wisconsin Gas & Electric Co. v. United States, 322 U.S. 526 (1944). /25/ Commissioner v. First Security Bank, 405 U.S. 394 (1972), upon which Hillsboro relies (H. Br. 8), is not in point. There, this Court ruled that the Commissioner could not allocate income under Section 482 of the Code to certain banking subsidiaries of a holding company where such subsidiaries did not receive and were legally prohibited from receiving the income in question. The present case, however, in no way involves an allocation of income, under Section 482 or otherwise, among related parties. Rather, the Commissioner's position here is based on the fact that the Bank itself enjoyed the benefit of a deduction that is no longer justified. /26/ There is no indication in the record that any part of the $56,565 liquidation date value was due to an increase in the market price of cattle feed between the date the feed was purchased and the date of liquidation. If that were the case, however, the amount includable in Bliss' income under the tax benefit rule would, of course, be limited to the actual cost of that feed. See Tennessee Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440, 448 (1975). It is the purpose of the tax benefit rule to counter-balance prior, unwarranted deductions, not to tax asset appreciation caused by market forces. /27/ The net result in these cases would be precisely the same as if the feed had been retained and used by the transferor itself in its succeeding taxable years, viz., there would have been a one-year deferral of tax to the extent the cost of unused feed was used to offset otherwise taxable income for the first year. While the use of inventory accounting in the first instance would have eliminated even this temporary distortion in income, the temporary shifting of income is considered too inconsequential to mandate the use of inventories in such cases. The transfer of property to a corporation in a transaction governed by Section 351 is similarly treated as a mere change of form, with the corporation taking the property subject to the same basis as it had in the hands of the transferor. See B. Bittker & J. Eustice, supra, Paragraphs 3-01 and 3.12. Cf. Nash v. United States, supra, 398 U.S. 1. /28/ Section 333 permits the shareholders to limit the amount of gain recognized on the liquidation to their pro rata shares of the corporation's earnings and profits or, if greater, the amount of money and certain securities acquired in the liquidation. /29/ Respondent Bliss Dairy (Br. in Opp. 2, 9) apparently takes the position that its shareholders did not take a "stepped-up" basis in the corporate assets, but took a carryover basis in those assets because their basis in the assets was equal to their basis in the stock of the corporation. But that is not a carryover basis within the parlance of the tax law. The term carryover basis connotes the same basis in the same item of property. Hence, if the shareholders took the corporation's zero basis in the feed, they could have a carryover basis because the corporation's basis would "carry over" to the shareholders. But where, as here, the shareholders' basis in the feed (and other assets) was computed by reference to their basis in their stock, their basis in the feed will necessarily be greater than zero. In these circumstances, they are said to have taken a "stepped-up" basis in the feed. /30/ Although the exact amount of the shareholders' "stepped-up" basis in the feed is not in the record, it is clear that the shareholders took a "stepped-up" basis to at least some degree. See page 5, note 4, supra. /31/ Had the corporation instead chosen to sell the expensed feed and to distribute the proceeds to the shareholders, it is settled that it would have been required to restore the previously deducted amount to income even though the liquidation might have qualified under the provisions of Section 337 of the Code (providing for nonrecognition of gain on the sale of property pursuant to a liquidation plan meeting the requirements of that section). See, e.g., Anders v. United States, 462 F.2d 1147 (Ct. Cl.), cert. denied, 409 U.S. 1064 (1972); Connery v. United States, 460 F.2d 1130 (3d Cir. 1972); Spitalny v. United States, 430 F.2d 195 (9th Cir. 1970); Commissioner v. Anders, 414 F.2d 1283 (10th Cir.), cert. denied, 396 U.S. 958 (1969). While the corporation itself, in such a case, converts the "expensed" property into money, the distribution of such property to shareholders, with a "stepped-up" basis -- enabling them either to claim a second deduction or to sell the property themselves, and thereby acquire the same amount of cash (largely or entirely tax-free) that they would have received had the corporation sold the property -- is, we submit, equally inconsistent with the assumptions under which the deduction was originally claimed and with the corporation's retention of the "tax benefit" resulting from its practice of deducting the cost of such property in advance of its consumption. Since the economic positions of the parties are precisely the same in both instances, the tax benefit rule is likewise applicable here. While this case and Tennessee-Carolina, supra, involve liquidation distributions, the same problem would be presented in an "inkind" distribution of "expensed" property in a non-liquidating context. In such a case, the shareholders would be charged with dividend income to the extent that the corporation had earnings and profits (Sections 301(a) and (c), and 316 of the Code). But absent the tax benefit rule, the corporation could retain the benefit of a tax deduction (and, hence, a reduction in earnings and profits) that becomes unjustified in light of the distribution. Thus, unless the tax benefit rule required the corporation to restore the previously deducted amount to income, a corporation could distribute "expensed" property remaining on hand at the end of each taxable year, and thereby enjoy the benefit of making annual tax-deductible dividends. Indeed, one could easily imagine a case in which the deduction for unconsumed materials distributed to shareholders would be sufficient to reduce earnings and profits to zero, thereby rendering such "dividends" non-taxable to the shareholders as well. /32/ It is in fact arguable that the discussion of the tax benefit rule in South Lake Farms is dicta. See 81-930 Pet. 8-9 n.6. The Ninth Circuit itself has subsequently recognized that Section 336 of the Code is not a bar to the inclusion of an overstated prior deduction in income in the year of liquidation. In Home Savings & Loan Association v. United States, 514 F.2d 1199 (9th Cir. 1975), the stock in a savings and loan association was first purchased by another savings and loan association, which thereafter liquidated the acquired association. The court held that the liquidated association was required to include in its income certain amounts it had deducted as additions to its bad debt reserve prior to the take-over and liquidation. At the time the liquidating corporation's assets were distributed to the acquiring parent corporation, it became clear that the projection of bad debt expenses inherent in the reserve account was overstated. The court viewed the liquidation and distribution as an event inconsistent with the former corporation's prior deductions for the reserves. Although the court stated in its opinion that it did not intend to impair the authority of South Lake Farms (514 F.2d at 1201 n.1), the holdings of Home Savings & Loan, on the one hand, and South Lake Farms and the present case, on the other, cannot fairly be reconciled. See First Trust & Savings Bank v. United States, supra, 614 F.2d 1146 n.5. /33/ Compare, e.g., Nash v. United States, supra, 398 U.S. 1, where stock received on the transfer of the unincorporated business to a corporation reflected the actual "net" value of accounts receivable, and thus did not constitute a "recovery" of the amount properly added to bad debt reserves. /34/ Despite the broad "no gain or loss" language of Section 337, the courts have required the recognition of income on the sale of corporate assets in a variety of contexts, including, as noted above, the sale of previously "expensed" items (e.g., Anders and Spitalny, supra), the transfer of accounts receivable that had previously been written off in part through additions to a bad debt reserve (West Seattle National Bank v. Commissioner, 288 F.2d 47 (9th Cir. 1961)), and the transfer of contracts under which the right to receive partial or complete payment has already been earned (e.g., Commissioner v. Kuckenberg, 309 F.2d 202 (9th Cir. 1962), cert. denied, 373 U.S. 909 (1963)); Family Record Plan, Inc. v. Commissioner, 309 F.2d 208 (9th Cir. 1962), cert. denied, 373 U.S. 910 (1963); and Midland-Ross Corp. v. United States, 485 F.2d 110 (6th Cir. 1973)). See B. Bittker & J. Eustice, supra, Paragraph 11.65, at 11-82 through 11-85. It is well established that Section 336 would not preclude attributing income to the corporation itself on assignment of income principles where the right to receive contract payments is distributed to shareholders. See, e.g., Wood Harmon Corp. v. United States, 311 F.2d 918, 921-923 (2d Cir. 1963); Williamson v. United States, 292 F.2d 524, 528-530 (Ct. Cl. 1961). Given the purpose of Section 337 to eliminate the disparity in treatment between liquidation sales and liquidation distributions, the Sixth Circuit properly concluded that Section 337 should be construed, insofar as possible, so as to achieve the same result. Midland-Ross Corp. v. United States, supra, 485 F.2d at 114-115, 118. See also Estate of Munter v. Commissioner, 63 T.C. 663, 671-677 (1975). /35/ Indeed, in a Secton 333 liquidation, such as here, the result is even more egregious because the shareholders' "gain" on the liquidation distribution is itself limited to their pro rata share of corporate earnings and profits which, of course, are themselves reduced by the deductions for items that were not actually consumed in the corporation's own operations. Appendix Omitted