Friday, August 25, 2006
The issue in employee discounts is whether we should interpret Congress to have intended to exclude compensation for services rendered under 132 permanently (basis credit for the discount) or only to defer it (no basis credit for the discount). That's all. It is a statutory interpretation argument regarding which sorts of "compensation for services rendered" was intended to be permanently tax free and which were not. It uses "policy" to determine the wisdom or folly of one interpration of the language over the other. And the policy argument itself assumed that the modern rationale underlying "basis" is NOT that it's a political/policy concept but rather a structural concept core to the meaning of "income": that it's a running record of previously taxed dollars (or, put another way, dollars that have not yet been deducted).
I need to make a distincition between "modern" basis theory and historical basis theory at the time of the adoption of the modern income tax, though. That this is the modern "core concept" underlying basis is evident in the dozens of Code provisions that have as their purpose to keep this running record of previously taxed dollars. So you get basis on a nondeductible capital expenditure or the inclusion of an item of property received in kind. You reduce basis as it is deducted, and you increase basis as you make additional nondeductible permanent improvements. In Subchapters K and S, it is the most important tool used to keep track of previously taxed dollars. There is so much throughout the Internal Revenue Code that I don't think it can be argued today that the "core" function of basis in the modern world is other than to keep track of previously taxed (not yet deducted) dollars. (That does NOT mean that there are no statutory "policy" exceptions to this core concept, but they are just that: deviations from the core concept for a policy reason that is considered--rightly or wrongly--to be strong enough to justify the deviation. Sort of like "tax expenditure" deductions for home mortgage interest.)
And the reason that this function is core to the concept of an "income" tax (as opposed to, say, a property tax)is to ensure that the same dollars are not taxed to the same taxpayer more than once or deducted by the same taxpayer more than once. So when you buy Blackacre for $20,000 (nondeductible capital expenditure), we need to keep track of the fact that you have already been taxed on that purchase price in the year of purchase so that, when you sell it for $23,000, you are not taxed on the entire $23,000 in cold hard cash now in your hands but only on the $3,000 that has not yet been taxed to you. And when you buy a building for use in your business for $30,000, it appreciates to $50,000 (and it can clearly be shown that this is its true economic value), it burns to the ground, and you are uninsured, you get only a $30,000 loss deduction under section 165(b) (ignoring depreciation changes to basis prior to the fire for simplicity), even though you clearly lost $50,000 in real economic value. What would be wrong with allowing you to deduct the entire economic value that you actually lost in business? Because of the realization requirement, you didn't include that appreciation in gross income, so allowing a $50,000 deduction would allow a double tax benefit for the same dollars ($20,000 exclusion coupled with $20,000 deduction). Basis is the core "structural" concept that implements an income tax in the modern sense.
All this basis analysis has nothing to do with "policy" except in the sense that it relates to the previous decision to tax "income" and that an income tax generally disallows the same dollars to be taxed to the same taxpayer more than once and disallows the same dollars to provide a double tax benefit to the same taxpayer more than once. Basis is a "tool" used to implement these notions of what it means to tax "income" and not something else (such as an ad valorem property tax, which taxes the same dollars to the same taxpayer more than once).
Allowing Murphy to exclude the pain and suffering damages as a "tax-free recovery of basis" is wrong under modern basis concepts in that there are no previously taxed dollars (nondeductible capital expenditure) to recover tax free here. She made no nondeductible capital expenditure that created her bodily integrity. Allowing her both to exclude the enjoyment she had in life prior to the injury (as we do) and "deduct" that loss in enjoyment as a "basis offset" against the settlement proceeds is wrong for the same reason that it would be wrong to allow our building owner above to deduct the full economic loss incurred of $50,000 instead of only the previously taxed dollars that the taxpayer had included with respect to that building.
If you stick with modern basis theory--that it's prime role in the Internal Revenue Code is to be a running record of previously taxed dollars in order to ensure that the same dollars are not twice taxed or twice deducted (or otherwise provide a double tax benefit) to the same taxpayer--Murphy simply makes no sense as a "basis" case. The only way that it can be defended on "basis" grounds (I'll address other grounds shortly), in my view, is if you read Murphy to require that ANTIQUATED notions of "basis" prominent in 1913 must control. Perhaps that's what they were trying to say when they said they were going with an "originalist" conception of "income." I think what they were really saying is that they were going with antiquated notions of "basis."
Back in the day, basis was NOT well understood as having the core function of being a running record of previously taxed dollars. It was thought of as "value." That's why nothing more than a regulation under the predecessor to 1012 said that property received gratuitously (such as at death) took a FMV basis. It wasn't thought of as a huge, policy decision. Because property purchased with cash essentially took a FMV basis, property obtained gratuitously took the "same" approach: FMV. This led to inter vivos gifting to wipe out built-in gain and, eventually, section 1015 and Irwin v. Gavit. The FMV-at-death basis rule, even though death was not a realization event (resulting in dollars going untaxed anywhere) was then clearly thought of as a "deviation" from the core concept that basis represents previously taxed dollars. (Even Crane basis is thought to represent dollars that will be taxed upon the nondeductible repayment of the loan principal; it's merely accelerated.) The early personal injury rulings cited by the Murphy court likely WERE "basis" cases in the sense that they were decided at a time when it was not well understood that the role of basis is to keep track of previously taxed dollars. These rulings were decided at a time when basis was simply ALWAYS assumed to mean "FMV."
But if that's what the Murphy court was saying--that the post 1913 evolution of "basis" cannot stand (that we need to be frozen at 1913 regarding our understanding of basis as essentially being FMV, period, even if not representing previously taxed dollars)--then a carryover basis at death (as under new 1022 in 2010) would also be unconstitutional. Perhaps even 1015 would be unconstitutional. Those all occurred as a result of our greater understanding over the years of the "structural" role of basis in keeping track of previously taxed dollars to ensure the "no double tax or double benefit for the same dollars" value implicit in an income tax. Freezing "basis" concepts to those concepts that were prevalent in 1913 (as opposed to the modern understanding of basis) simply makes no intellectual sense to me.
If the Murphy outcome is to be upheld, I think it has to be upheld on "pure policy" grounds, not basis. The statutory interpretation question there would be whether the residual language in section 61 (gross income is income from whatever source derived) is strong enough to sustain the IRS's argument that the cash settlement is includable. I do think the very opaqueness of the language in the residual clause gives courts greater ability to conclude that something is "not gross income" if that's the only language that would cover it (i.e., it is not a listed item in section 61), but usually that broader ability to conclude "no gross income" under the residual clause is exercised only in cases not involving cash but rather consumption in kind (such as Mr. Gotcher's air fare, hotel, and meals). I can't think of a modern case offhand that held (other than on outdated "basis" analysis) that cash is not gross income. Here, you would consider the effect on tortfeasors, who could get away with paying less if the jury knew it was tax-free; you would evaluate ability-to-pay, particularly since an injured party who actually received a settlement is so much better off than an equally injured party who gets injured by Mother Nature or a shallow pocket and "can't sue God," as someone else once wrote, etc. On pure policy grounds, it's not a very winning argument, to me, which means that the IRS's position that the residual clause is broad enough to encompass the cash is a reasonable interpretation of the language and should be upheld.