UNITED STATES OF AMERICA, PETITIONER V. BLISS DAIRY, INC.

   No. 81-930

   In the Supreme Court of the United States

   October Term, 1981

   The Solicitor General, on behalf of the United States of America,
petitions for a writ of certiorari to review the judgment of the
United States Court of Appeals for the Ninth Circuit in this case.

   Petition for a Writ of Certiorari to the United States Court of
Appeals for the Ninth Circuit

            TABLE OF CONTENTS
   Opinions below
   Jurisdiction
   Statutes involved
   Statement
   Reasons for granting the petition
   Conclusion
   Appendix A
   Appendix B
   Appendix C
   Appendix D
   Appendix E

                            OPINIONS BELOW

   The opinion of the district court (App. A, infra, 1a) is not
reported.  The opinion of the court of appeals (App. B, infra, 2a-5a)
is reported at 645 F.2d 19.

                             JURISDICTION

   The judgment of the court of appeals was entered on May 11, 1981
(App. C, infra, 6a).  The order denying the government's petition for
rehearing (App. D, infra, 7a) was entered on July 31, 1981.  By order
dated October 21, 1981, Justice Rehnquist extended the time within
which the government could file a petition for a writ of certiorari to
and including November 21, 1981.  The jurisdiction of this Court is
invoked under 28 U.S.C. 1254(1).

                           STATUTES INVOLVED

   The relevant provisions of Sections 332, 333, 334, 336 and 337 of
the Internal Revenue Code of 1954 (26 U.S.C.) are set forth in App. E,
infra, 8a-10a.

                          QUESTION PRESENTED

   Whether a liquidating corporation was required to include in its
gross income for the year of its liquidation an amount equal to the
value of unconsumed cattle feed 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 enabling them
to claim a further deduction for the feed when it was consumed during
their subsequent operation of the business.

                               STATEMENT

   Respondent was engaged in the business of operating a dairy.  It
kept its books and filed its income tax returns using the cash method
of accounting, with a fiscal and taxable year beginning on July 1 and
ending on June 30.  During its taxable year ending June 30, 1973,
respondent 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 (App. B,
infra, 2a-3a).

   On July 2, 1973, two days into the following taxable year,
respondent adopted a plan of liquidation pursuant to Section 333 of
the Internal Revenue Code of 1954.  That provision allows the
shareholders of a corporation, under certain conditions, to receive
the corporation's assets during a one-month liquidation without
recognizing gain or loss.  During the month of July 1973, respondent
distributed all of its assets to its shareholders pro rata.  Among the
assets so distributed was the unconsumed cattle feed that respondent
had deducted as an expense in the preceding taxable year.
Respondent's shareholders thereafter continued the dairy business.  As
a result of the liquidation, the shareholders acquired "stepped-up"
tax bases in the feed, thereby allowing them the benefit of further
deductions for the feed on their 1973 individual income tax returns
(App. B, infra, 3a).

   On audit of respondent's federal income tax return for its final
taxable year (July 1, 1973 -- July 31, 1973), the Commissioner of
Internal Revenue increased respondent's gross income by $60,000,
representing the value of the unconsumed feed distributed to its
shareholders.  Respondent 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" (App. A, infra, 1a).

   The court of appeals affirmed on the authority of its prior
decision in South Lake Farms.  There it refused to apply the tax
benefit rule in comparable circumstances involving the liquidation of
a subsidiary corporation into its parent under Section 332 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 Lake
Farms" (App. B, infra, 4a).  See Tennessee-Carolina Transportation,
Inc. v. Commissioner, 482 F.2d 378 (6th Cir. 1978), cert. denied, 440
U.S. 909 (1979);  First Trust & Savings Bank of Taylorville V. United
States, 614 F.2d 1142 (7th Cir. 1980);  and Hillsboro National Bank V.
Commissioner, 641 F.2d 529 (7th Cir. 1981), petition for cert.
pending, No. 81-485.

                   REASONS FOR GRANTING THE PETITION

   1. In holding that respondent was not required to include in income
for the year of its liquidation an amount representing the value of
the unused feed that it had deducted in the prior taxable year, the
court of appeals acknowledged that its decision conflicted with those
of two other courts of appeals.  In Tennessee-Carolina, supra, the
Sixth Circuit held, in virtually identical circumstances, that the tax
benefit rule (see pages 5-6, infra) required a liquidating corporation
to include in gross income for the year of liquidation an amount equal
to the value of property that was previously the subject of a tax
deduction and that it distributed to its sole shareholder.  In First
Trust and Hillsboro National Bank, supra, the Seventh Circuit
similarly held that the tax benefit rule required a corporation which
had previously paid and deducted state property taxes imposed on its
shareholders to restore the deduction to income in the year that the
taxes were refunded to its shareholders.

   The issue is both recurring and important to the administration of
the revenue laws.  Since 1978, controversies involving the application
of the tax benefit rule in circumstances similar to those here or in
First Trust and Hillsboro National Bank have been litigated six times.
 /1/ We are, moreover, advised by the Internal Revenue Sevice that
there are at least 15 cases pending at the appellate administrative
level presenting the question, with $1,743,000 in income taxes at
stake.  This Court should resolve the conflict among the circuits in
order to establish a uniform national rule.  /2/

   2.a. One of the fundamental principles upon which the federal
system of income taxation is based is the annual accounting system.
See Section 441 of the Internal Revenue Code of 1954;  Burnet v.
Sanford & Brooks Co., 282 U.S. 359 (1931).  As this Court stated in
United States v. Consolidated Edison Co., 366 U.S. 380, 384 (1961):
"It is settled that each 'taxable year' must be treated as a separate
unit, and all items of gross income and deduction must be reflected in
terms of their posture at the close of such year."

   The annual accounting system draws arbitrary lines between taxable
years.  As a result, situations necessarily arise 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.  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 correcting transaction
actually occurred.  See, e.g., Burnet v. Sanford & Brooks Co., supra,
282 U.S. at 365;  Healy v. Commissioner, 345 U.S. 278 (1953).

   One of the principles developed by the courts to deal with such
subsequent year reportings is the "tax benefit rule," which is
designed to ensure a measure of tax parity in the effect of an earlier
deduction and later correcting return.  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.  /3/ Rosen v. Commissioner, 611
F.2d 942, 943 (1st Cir. 1980).

   Here, respondent employed a method of accounting under which the
cost of acquiring cattle feed was currently deducted as an expense
without regard to whether it was fully consumed in the year of
acquisition.  /4/ At the time of its liquidation, respondent held
approximately $60,000 worth of cattle feed, for which it had
previously claimed a business expense deduction.  As a result of the
liquidation, the unused feed was distributed to its shareholders who
thereafter continued to engage in the dairy business.  Having acquired
"stepped-up" tax bases in the feed, the shareholders took further tax
deductions for the feed on their individual income tax returns for
1973.  /5/

   The tax benefit rule requires that respondent's gross income for
its final taxable year be increased by an amount equal to that portion
of the prior deduction attributable to the unconsumed feed distributed
to its shareholders.  Although respondent properly deducted the cost
of the feed in the previous taxable year when it was purchased, that
deduction was premised on the assumption that the feed would, in fact,
be consumed in respondent's trade or business within a relatively
short period and that no substantial distortion of income would result
even though some portion might not be consumed until a later taxable
year.  But that factual assumption proved to be unwarranted.  Instead,
respondent discontinued its business before the feed was actually
consumed.  Once the business with respect to which respondent had
taken a deduction of $150,199 came to an end as a result of the
liquidation in July 1973, respondent had outstanding a deduction for
feed which it in fact would never consume.  The integrity of the
annual accounting system therefore demands that the amount of the
excess deduction should be included in respondent's gross income for
the year of liquidation.

   b. Although the court below adhered to its prior decision in
Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (1963), the
limitation imposed by that case upon the tax benefit rule has been
rejected by the other courts of appeals that have considered the
question.  /6/ In Tennessee-Carolina Transportation, Inc. v.
Commissioner, supra, the taxpayer Service Lines, Inc., was engaged in
the motor freight transportation business, and regularly purchased
tires and tubes for use in that business.  Because the tires and tubes
had useful lives of only one year, the taxpayer was permitted to
deduct their full cost at the time of purchase as a business expense.
At the time of its liquidation, the taxpayer distributed the
previously expensed tires and tubes, then worth approximately $36,000,
to Tennessee-Carolina, which had recently acquired all of Service's
stock.  Pursuant to Section 334(b)(2) of the Code, Tennessee-Carolina
claimed a "stepped-up" basis in those tires and tubes equal to their
value at the time of distribution, and thereafter claimed business
expense deductions in that amount when the tires and tubes were
consumed.

   On these virtually identical facts, both the Tax Court and the
Sixth Circuit held that Service had to include the liquidation date
value of the tires and tubes in its income under the tax benefit rule,
notwithstanding the nonrecognition provisions of Section 336.  In so
holding, the court of appeals stated (582 F.2d at 382):  "The tax
benefit rule should be applied flexibly in order to counteract the
inflexibility of the annual accounting concept which is necessary for
administration of the tax laws." Rejecting the contrary suggestion of
South Lake Farms, the court concluded that "there need not be an
actual physical 'recovery' of some tangible asset or sum in order to
apply the tax benefit rule," but that the rule could properly be
invoked "whenever there is an actual recovery of a previously deducted
amount or when there is some other event inconsistent with that prior
deduction" (ibid.; emphasis in original).  See Estate of Block v.
Commissioner, 39 B.T.A. 338, 340-341 (1939), aff'd, 111 F.2d 60 (7th
Cir.), cert. denied, 311 U.S. 658 (1940).  In the court's view, such
an inconsistent event had occurred when the taxpayer ceased its
operations and transferred to its parent valuable assets which thereby
acquired a "stepped-up" basis even though they had previously been
deducted in full on the theory that they would be "totally used up" by
the taxpayer itself.  582 F.2d at 382.  /7/

   The Seventh Circuit, in First Trust & Savings Bank of Taylorville
v. United States, supra, and Hillsboro National Bank v. Commissioner,
supra, has likewise rejected the narrow view of the tax benefit rule
taken by South Lake Farms.  In each of those cases, the court ruled
that a taxpayer-bank realized income under the tax benefit rule when
personal property taxes it had paid on behalf of its shareholders and
deducted from its federal income tax pursuant to Section 164(e) of the
Code, were refunded to the shareholders themselves in the next year.
In both cases, the court rejected the notion that the tax benefit rule
cannot be applied unless the taxpayer itself recovers the deducted
amount.  It concluded that the amounts were includable in the bank's
income because the refunds to the shareholders were events
inconsistent with the bank's prior deduction of the taxes.  See 614
F.2d at 1145-1146;  641 F.2d at 531.  /8/

   Contrary to the decision below and South Lake Farms to which it
adhered, the Sixth and Seventh Circuits correctly analyzed the
practicalities and economics that form the basis for the tax benefit
rule.  It may well be that the inconsistent event that ordinarily
triggers application of the tax benefit rule is the actual recovery of
a previously deducted amount.  But that is not the only situation
which calls for application of the tax benefit rule.  The rule
necessarily applies whenever subsequent events are factually
inconsistent with the retention of previously claimed tax benefits.
This can occur when the recovery of a previously deducted amount is
secured by related persons (as in First Trust and Hillsboro National
Bank) or when there is a "step-up" in the basis of property that has
previously been "expensed" but never actually used in the operation of
the taxpayer's trade or business, as was the case here and in
Tennessee-Carolina.  In both of those instances, subsequent events
undermine the factual basis of the prior year's treatment and are
inconsistent with the retention of previously claimed tax benefits.
Since the annual accounting system ordinarily precludes reopening of
the prior year's return, it is appropriate that gross income be
increased for the year in which events occur that demonstrate that a
prior year's deduction is no longer justified.

   3. As the Sixth Circuit recognized in Tennessee-Carolina, there is
another reason why the tax benefit rule should be applied in the case
of liquidating distributions of property the cost of which the
distributing corporation has previously deducted as an ordinary and
necessary business expense.  The failure to apply the rule in that
context results in a substantial disparity between the tax
consequences flowing to the parties where property is sold by the
liquidating corporation in a transaction under Section 337 and the tax
consequence where the property is transferred instead directly to the
shareholders in a liquidating distribution governed by Section 336.
The provisions now contained in Section 337 were adopted in order to
eliminate the disparity in the tax treatment of such transactions
under this Court's prior decisions in Commissioner v. Court Holding
Co., 324 U.S. 331 (1945), and United States v. Cumberland Public
Service Co., 338 U.S. 451 (1950).  See H.R. Rep. No. 1337, 83d Cong.,
2d Sess. A106 (1954);  S. Rep. No. 1622, 83d Cong., 2d Sess. 258-259
(1954).  Thus, just as Section 336 provides, as a general rule, that
no gain or loss is recognized by the liquidating corporation on the
distribution of property to shareholders on liquidation, Section 337
provides, as a general rule, that no gain or loss is to be recognized
by the liquidating corporation on a sale of property pursuant to a
qualifying plan of liquidation.

   Despite the nonrecognition provisions of Section 337, however, the
courts have consistently held that the tax benefit rule requires that
a liquidating corporation that sells its assets pursuant to Section
337 include in gross income an amount equal to the value of those
items it has previously "expensed." The leading precedent, in this
regard, is Commissioner v. Anders, 414 F.2d 1283 (10th Cir.), cert.
denied, 396 U.S. 958 (1969).  There, a corporation that had engaged in
the business of renting towels, clothing and certain other products
was liquidated.  Even though the rental items had useful lives which
often extended into subsequent tax periods, as in the instant case and
in Tennessee-Carolina, it claimed an immediate deduction of all
amounts expended for those items.  Accordingly, the corporation
carried its rental materials on the books as fully expensed.
Following the adoption of a plan of liquidation, all of its assets
were sold and the proceeds were distributed to the shareholders in a
transaction meeting the requirements of Section 337.  The corporation
took the position that the amount it realized on the sale of
previously expensed rental items was tax-free under the nonrecognition
provisions of that statute.  The court, however, held that the tax
benefit rule required the inclusion in income of the previously
expensed items.  As the court stated (414 F.2d at 1287-1288;  footnote
omitted):

      The rental items in question had a zero basis and their cost had
      been fully expensed on purchase by Service in its Federal income
      tax returns and deductions were taken therefore by Service.  * *
      * In view of Service's charging the full cost of the rental
      items to expense, the "* * * increment realized in this area
      over and beyond adjustment basis does not then represent any
      gain in capital or asset value." West Seattle National Bank of
      Seattle v. Commissioner, supra, 288 F.2d at 49.  * * * We
      conclude that the logic of tax benefit principles applies here,
      despite various distinctions suggested between Service's case
      and existing tax benefit decisions.  Under such principles the
      proceeds of the rental items should properly be treated as
      recoupment of the expense charges.

   Accord, Anders V. United States, 462 F.2d 1147 (Ct. Cl.), cert.
denied, 409 U.S. 1064 (1972);  Spitalny v. United States, 430 F.2d 195
(9th Cir. 1970).

   If the decision below is permitted to stand, a corporation may
easily escape the consequences of the tax benefit rule simply by
distributing its assets to its shareholders, who may then sell the
assets or use them in a continuing business, taking a second deduction
in the amount of the "stepped-up" basis claimed under Section 334.
But 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, Federal Income Taxation of Corporations and Shareholders
Paragraph 11.65 (4th ed. 1979).  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 Sec. 337."
Tennessee-Carolina Transportation, Inc. v. Commissioner, supra, 582
F.2d at 383 (footnote omitted).

                              CONCLUSION

   The petition for a writ of certiorari should be granted.

   Respectfully submitted.

   REX E. LEE

      Solicitor General

   JOHN F. MURRAY

      Acting Assistant Attorney General

   STUART A. SMITH

      Assistant to the Solicitor General

   GARY R. ALLEN

      Attorney

   NOVEMBER 1981

   /1/ In addition to the instant case, and the cases cited above, see
Bonaire Development Co. v. Commissioner, 76 T.C. 789 (1981), appeal
pending, No. 81-7469 (9th Cir.);  Ballou Construction Co. v. United
States, No. 79-4138 (D. Kan. Aug. 4, 1981), appeal pending, No.
81-2155 (10th Cir.)

   /2/ Because the petition for a writ of certiorari in Hillsboro
National Bank (No. 81-485) presents the same legal question in a
different factual context, we are not opposing that petition but
suggest that the Court may wish to consolidate this case and Hillsboro
National Bank for briefing and oral argument.  We are serving a copy
of this petition on counsel for the petitioner in No. 81-485.

   /3/ While the "tax benefit rule" originated as a judicially devised
principle of general application, it has received statutory
recognition in the form of the provisions now set forth in Section 111
of the Code.  That statute, however, does not, by its terms, codify
the rule itself, but serves only to limit the amount of subsequent
inclusion to that portion of the prior tax deduction that led to an
actual tax benefit.  See H.R. Rep. No. 2333, 77th Cong., 2d Sess. 45
(1942).

   /4/ This accounting method is based upon the premise that such a
system of reporting would not result in a distortion of income.  In an
on-going dairy business, these types of expenditures will necessarily
be made in roughly equal amounts from year to year.  In these
circumstances, the taxpayer is not required to match its deductions
with actual usage through the use of inventory accounting.

   /5/ Respondent was liquidated pursuant to Section 333 of the Code,
which generally provides that if the shareholders so elect and the
liquidation is accomplished within one month, then the shareholders
may receive liquidating distributions tax-free.  Section 334(c) of the
Code provides, in such circumstances, that the shareholders' bases in
their stock shall generally carry over to the property distributed to
them in the liquidation.  In the present case, these provisions
permitted taxpayer's shareholders to increase the tax basis of the
feed from zero at which it was carried on respondent's books to
reflect a ratable portion of the basis in their stock.  Hence, the
shareholders were able to claim a deduction on their own returns equal
to that "stepped-up" basis when the feed was consumed.

   /6/ It is in fact arguable that the discussion of the tax benefit
rule in South Lake Farms is dicta.  The only issues presented to the
Tax Court in that case were (1) whether the Commissioner had the
authority under Section 446(b) of the Code to require a corporation to
change its accounting methods and to include an amount representing
the value of growing crops in income for the year in which it
distributed all its assets to its sole shareholder, and (2) whether,
in the alternative, the Commissioner had the authority to deny a
deduction for crop growing expenses under Section 482 of the Code.
The Tax Court rejected both contentions, and the court of appeals
affirmed, with one judge dissenting.  The court held (324 F.2d at 838)
that no method of accounting required a taxpayer to include the
liquidation value of the unharvested crops in its gross income.

   However, the court went on to observe, in a discussion that is not
central to the holding, that the absence of an actual "recovery" of a
previously expensed item in the form of the taxpayer's receipt of
"money or property equal to the amount previously spent and deducted"
precluded the application of the tax benefit rule in some
circumstances (324 F.2d at 840).  Although the court conceded that the
prior deduction resulted in a "tax windfall" to the taxpayer and its
former shareholders, it nevertheless concluded that the Code
provisions dealing with the treatment of liquidation distributions
(Sections 334, 336 and 337) indicated that Congress did not intend
that a liquidating corporation be charged with additional income on
the distribution of such property to its shareholders (324 F.2d at
840).

   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 of Taylorville v.
United States, supra, 614 F.2d 1146 n.5.

   /7/ The court further noted that even if some form of "recovery"
must occur before the tax benefit rule may be applied, there was
sufficient recovery on the conversion of the "zero basis" tires and
tubes into valuable assets that could take a "stepped-up" basis on
distribution, and that, at all events, an "actual recovery" occurred
when Service exchanged those assets for stock that had an equivalent
value at the time of the transfer (582 F.2d at 382).

   /8/ The Ninth Circuit itself in a recent case cited First Trust
with approval.  In Unvert v. Commissioner, 48 A.F.T.R. 2d Paragraph
81-5225 (Sept. 14, 1981), the court ruled that a taxpayer had to
include in income the amount of prepaid interest it recovered where it
had deducted that amount in a prior taxable year.  While there was an
actual recovery in that case, the court apparently approved the broad
formulation of the tax benefit rule set forth in First Trust.

   Appendix Omitted