Paul L. Caron

Friday, August 25, 2006

Geier: Murphy and the Role of Basis in the Tax Law

Geier_3 Deborah A. Geier (Cleveland State) offers her thoughts on Murphy v. United States, No. 03cv02414 (D.C. Cir. 8/22/06):

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.

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I don't understand any part of you wrote. Let me explain.

I agree that 262 does not let you take deductions for personal expenses. Anything which allowed a deduction for personal expenses would “gut” 262.
But creating a basis in your bodily health isn't the same as allowing a deduction for personal expenses.
To put it another way, you can have a basis in your bodily health, even though you're not allowed to deduct some of the personal expenses (like vacations) which build bodily health. It is precisely because you can't deduct all of the personal expenses which build bodily health that you should be given a basis in your bodily health. If you could deduct all such expenses then it would not make any sense to give you a basis in your bodily health, because it would have been created with before tax dollars.

I just don't see how your claim that allowing people a basis in their mental health would "gut" 262 is right.

Bottom line is this. If people like you and Ms. Geier want to double tax the person described in the example I provide above, then that is fine. However, in my opinion it is intellectually dishonest on your part to claim that basis theory is inconsistent with the Murphy ruling.

Posted by: Anonymous | Aug 28, 2006 4:45:01 PM

"Enjoyed personal items purchased with after tax dollars don't generate deductions, and don't lose their basis (houses, etc.). . . . The issue is (ignoring the flawed constitutional analysis in Murphy) whether there is basis in mental health or the other aspects of ones body because it was clearly created with after-tax (non-deducted) dollars."

Two problems with the foregoing analysis. First, it is circular. The reason that mental health expenditures are "after-tax (non-deducted) dollars" is that Congress has denied income tax deductions, except as expressly provided in the Code, for personal, living, or family expenses. IRC section 262. Such dollars are not "after-tax (non-deducted) dollars" because they must be capitalized (and later deducted) under section 263, but rather, because such dollars are never deductible. Sticking personal mental health expenditures in bodily "basis," if permitted, would gut section 262. One might argue (and tax protestors have) that the meals we eat are a personal investment that creates "basis" in our bodies.

Second, a house is a flawed example of personal expenses that create basis. This ignores the distinction between capital expenditures, such as adding a room to your house, and costs of routine upkeep and repairs, such as replacing a light bulb.

Posted by: Jake | Aug 27, 2006 2:34:20 PM

Deborah A. Geier wrote in Murphy v. United States

"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..

Having said that(I agree),perhaps Ms. Geier would like to explain precisely what it is about the language in section 111(a) of the Internal Revenue Code that permits IRS to issue instructions that result in the gross income attributable to an itemized deduction recovery exceeding the amount of the recovery. This can happen when the recovery is included in the calculation of taxable Social Security benefits.

Or perhaps she would like to explain what it is about the language in section 56(b)(1)(D) of the IRC that provides for the exclusion from Alternative Minimum Taxable Income of tax refunds from years when the regular tax was paid. The language in section 56(b)(1)(D) only provides for the exclusion of a tax refund from Alternative Minimum Taxable Income when the the refund is from a year when the AMT was paid.

It should be noted that IRS instuction provide for the inclusion in gross income of a refund of a tax overpayment that provided only a limited capital gains rate based tax benefit in a year that the AMT was paid. Thus, if IRS instructions are followed, the taxpayer is DOUBLE TAXED. First, he is taxed at the AMT rate on the income used for the overpayment and then at the regular tax rate on the refund of the income used for the overpayment. Quite clearly under section 111(a), the refund should only impact the calculation of capital gains portion of the regular tax in this situation.

In summary, because of IRS's fraudulent instructions, the sequence in which the AMT and regular tax is paid determines whether the income/refund related to a tax overpayment is taxed "DOUBLE OR NOTHING".

By the way, I agree with the Courts ruling.

William David Kebschull

Posted by: William David Kebschull | Aug 25, 2006 11:28:34 AM

Anonymous's post hits the point. A full theory of "after tax dollars (undeducted dollars)/basis", as Grier states, must deal with cost of goods sold and the like on a personal level. Capitalization v. deduction in a deep theory of basis (as it has been referred to) is an arbitrary destinction (one year v. more than one). Enjoyed personal items purchased with after tax dollars don't generate deductions, and don't lose their basis (houses, etc.). Though no loss can (normally) be taken, they can protect the individual from gain. The issue is (ignoring the flawed constitutional analysis in Murphy) whether there is basis in mental health or the other aspects of ones body because it was clearly created with after-tax (non-deducted) dollars.

Posted by: Dean Weiner | Aug 25, 2006 9:02:38 AM

Board moderator,
Thank you for fixing the mis-spelling of Ms. Geier's name. Can you please fix the 2nd mis-spelling also?
Many thanks.

Posted by: anonymous | Aug 25, 2006 8:54:44 AM

I'm not sure I understand what Ms. Geier is saying. Let me explain via an example.

Say I pay $5,000 for a vacation which results in an xx% increase in my mental health. Who tracks the basis I should get in that increase in my mental health? It was purchased with after-tax dollars after all. I don't get to deduct my vacation costs.

Then say through a tort, and emotional distress, that xx% increase is destroyed. I'm compensated for it in the amount of my vacation costs, namely $5,000. Seems fair so far. I'm back to where I was before the vacation.

But if we were to do things Ms. Geimer's way I would be taxed on that $5,000. I would be double taxed, wouldn't I?

Posted by: Anonymous | Aug 25, 2006 6:10:32 AM