Lesson From The Tax Court: The Actual Payment Doctrine

Today is a lesson in timing.  When I teach timing I emphasize to my students that they must analyze income items separately from deduction items.  Today is an example of how the analysis applicable to inclusion can be different from the analysis applicable to deductions.

As to income, we all know about the constructive receipt doctrine.  Even if a taxpayer has not actually received some slug of money, they are deemed to have constructively received it if the money was made available to them in the year and there was no legal restriction on their accessing it.

Today’s lesson teaches that the deduction analysis is different.  To take a deduction the taxpayer must make an actual payment.  There is no such thing as constructive payment.  In Edwin L. Gage and Elain R. Gage v. Commissioner, T.C. Memo. 2023-47 (Apr. 12, 2023) (Judge Holmes), the taxpayers purchased a cashier’s check in December 2012 to settle a lawsuit and gave it to their attorney.  They took a 162 deduction for 2012, even though their attorney did not deliver the cashier's check to to the opposing party until March 2013.  In holding that they could not deduct that payment in 2012, Judge Holmes explains why their commitment to pay and their actual purchase of a cashier’s check did not amount to making an actual payment in 2012.  Details below the fold.

Law:  Relation-Back Doctrine v. Constructive Payment Doctrine
Let’s start with a brief review on fundamental timing rules in tax.  The Supreme Court has explained that  “[i]t is the essence of any system of taxation that it should produce revenue ascertainable, and payable to the government, at regular intervals.”  Brunet v. Sanford & Brooks, 282 U.S. 359, 365 (1931).  Generally the regular intervals are yearly ones.  §441(a).  Congress wants to collect tax on a yearly basis from all taxpayers.

Taxpayers can generally choose what yearly period they want to use, and also can generally choose their how they want to account for their income and deductions within that one year period. §446(c).  Of course, those are just general rules.  See Lesson From The Tax Court: Generally Is Not Always—Or—That’s The Way The Ball Bounces, TaxProf Blog (Mar. 7, 2022).

Cash method taxpayers like the ones in today’s case generally report income the year they actually receive it. §451(a).  Similarly cash method taxpayers generally can take deductions the year they actually pay a deductible expense. Treas. Reg. 1.461-1(a)(1).

Remember, however, one must always treat income items separately from deduction items.  We see that difference when we go beyond actual receipt or payment to the concept of constructive receipt or payment.

On the income side, the constructive receipt doctrine is a huge exception to the general rule of actual receipt.  Treas. Reg. 1.451-2.  That doctrine says that cash method taxpayers must generally report as income even those amounts not actually received when those amounts have been“credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time.”  Id.  For details see Classic Lesson From The Tax Court: When Hornung Won The 'Vette, TaxProf Blog (Aug. 13, 2018).

You might think that what is true for the income goose is good for the deduction gander.  It seems only fair that if a cash-method taxpayer sufficiently commits to make a payment in a given year, then the taxpayer should be able to take the deduction even if the payment is not actually made until the following year.

Some might see Rev. Rul. 54-465 as support for the idea of a constructive payment doctrine.  There, the IRS ruled that a donation made to a charity by check could be deducted “in the taxable year in which the check is delivered provided the check is honored and paid and there are no restrictions as to time and manner of payment thereof.”  That seems like it speaks to the idea of a sufficient commitment to pay.

Indeed, the IRS has gone even further.  Rev. Rul. 54-465 was based on a check being actually delivered.  But what about when the check is just mailed on December 31st and not actually delivered (much less cashed) until January?  Well, golly, the IRS says that even there “the taxpayer is entitled to allowable deductions therefor on the day the checks are placed in the mail, provided the checks are subsequently paid by the bank.”  Rev. Rul. 80-843, 1980–2 C.B. 170. (sorry, no free link).  Heck, courts have also permitted taxpayers to take deductions for payments mailed on the last day of the tax year. See  Witt v. Fahs, 160 F. Supp. 521 (S.D. Fla. 1956).  While most cases involve charitable deductions—and there is even a special rule for that in Treas. Reg. 1.170A-1(b)—not all do.  The rule as stated and re-stated in IRS guidance and caselaw has been applied to basic business deductions as well.  See e.g. Rev. Rule. 80-843, supra, Clark v. Commissioner of Internal Revenue, 253 F.2d 745, 748 (3d Cir. 1958) (as to general business expenses deductible under §162, “as a general proposition delivery of a check will establish the same right to a deduction as would delivery of cash. It does not matter that the check was not cashed or deposited or the drawer's account charged until the following year.”)

So this might lead one to think that if a taxpayer takes an action sufficiently committing to payment—such as by putting a check in the mail—then that action supports a corresponding deduction.

And yet.  And yet.  Seemingly cutting against this understanding are cases like Vander Poel, Francis & Co., 8 T.C. 407 (1947).  There, the Tax Court held that a cash method company could not deduct salaries credited to the accounts of its officers (but not actually paid to them), even though the officers themselves had to include the salaries as income under constructive receipt principles.  After reviewing the case law and the treatises, the court concluded that “the weight of authority . . . is against the doctrine that ‘constructive payment’ is a necessary corollary of ‘constructive receipt.” Id. at 411.

How to explain this seemingly different set of results?  Well, I think of it this way.  The first set of rulings are really focused on whether checks should be treated the same as cash.  Someone who writes a check can always order the bank to not pay it, even after the check is sent away.  The basic idea behind the Revenue Ruling and the cases is that such ability to stop payment on a check does not prevent the check itself from being a payment.  If you mail off a $100 check, you have made a payment just as much as mailing off $100 cash.  [Note: it’s still not a good idea to send cash in the mail...or to eat Tide Pods.  Just sayin....]. 

The legal doctrine that treats a check-in-the-mail as a payment is derived from a commercial law doctrine that treats checks as a conditional payment.  The condition is that the check is honored when presented for payment to the bank it is drawn upon!  When that condition is met, the payment is regarded as absolute from the time the check was delivered.  That is why Rev. Rul. 54-465 explicitly relies on Estate of Modie J. Spiegel v. Commissioner, 12 T.C. 524, which explains the relation-back doctrine.  See also Metzger v. Commissioner, 38 F.3d 118 (4th Cir. 1994), for a really good discussion on the history and use of the relation-back doctrine in tax law and its limitations.

This relation-back doctrine is thus not a constructive payment doctrine.  It is not a doctrine that creates a deeming rule for when a payment is made.  It’s a doctrine that creates a deeming rule to treat payment by checks the same as payment by cash.  Checks are cash-equivalents.  For any payment to be deductible, however, the payment must be still be  actually made.  That’s what we will learn in today’s case.

Facts
Mr. and Ms. Gage indirectly owned a bunch of nursing homes in Oklahoma through various entities.  Those entities secured a big mortgage loan that was insured by the Department of Housing  and Urban Development (HUD).  The entities defaulted on the loan and HUD paid it off.  After selling the mortgage property, HUD still had a loss of over $4 million.  It filed suit to recoup its losses from the various entities and individuals, including the Gages.

In August 2012, the attorneys for all the parties agreed to a settlement of $1.75 million with $875,000 of that payable by the Gages.  Of course, settling with the federal government is never easy.  As any Department of Justice trial attorney will tell you, they cannot bind their client.  Rather, they can only recommend the settlement and it becomes final only when approved by a much higher official in the DOJ.  That takes time.  But the District Court Judge was so confident of approval that he administratively closed the case.

In December 2012, the DOJ higher-ups had not yet approved the settlement, although everyone involved remained confident approval was coming.  In late December, the Gages purchased a cashier’s check for $875,000 and gave it to their lawyer to give to the government.  But the DOJ attorney told their lawyer to hang onto it because the DOJ attorney was not allowed to accept the money until the DOJ higher-ups approved the settlement.

Final approval finally came in March and so the Gages’ attorney apparently had the check physically delivered to DOJ on March 18, 2013.  Op. at 5.

On their 2012 return, the Gages sought to deduct the $875,000 (and their legal feels), as resulting from a loss on business property.  The IRS disallowed the deduction for two reasons.  First, the IRS said the payment did not qualify for deduction under §162.  Second, the IRS said that even if the payment qualified, the Gages did not make the payment in 2012.

Judge Holmes decided the case on timing, holding that the Gages could claim no deduction in 2012 for the payment, even if it qualified under §162.  Let’s see why.

Lesson: Payments Must Be Actually Made To Be Deductible
Judge Holmes first recites the actual payment rule: “tax law treats a payment by check as made when the check is delivered.”  Op. at 6.  He might also have said when the check is mailed.  But even that expanded formulation does not help the Gages.  They never let go of their cashier’s check.  It just sat in their attorney’s office until March 2013.  Unlike handing it to the other party or putting it in the mail, they could have gone to their attorney at any time, retrieved the check, and canceled it.  Sure, it was a cash-equivalent but it was not mailed or given to the government until 2013.  It was no different than if they had given their attorney $875,000 in cash in a big suitcase to hold until the the government could accept payment.  The payment was in the attorney's office, waiting to be made, but it was not actually made.

The Gages focused on the fact that their attorney tried to give it to the DOJ attorney in 2012 but the DOJ attorney refused to take it.  They pointed to Oklahoma state law that created a constructive payment rule where it deems a tender of payment to be an actual payment.  They ask Judge Holmes to import that state law rule into federal tax law.

Their argument went nowhere.  It is true that federal tax sometimes does look to state commercial law.  The relation-back rule embedded in federal tax law is a great example.  The early Tax Court cases formulated the federal rule by relying on and extending state commercial law.  In fact, that is precisely what Judge Luttig on the Fourth Circuit complains about that in his dissent in Metzger: the “relation-back doctrine was created out of whole cloth by the Tax Court in 1949.”  38 F.3d at 124.

Judge Holmes was not about to use state law here to create a constructive payment rule. While state law might help federal courts create a general rule deeming checks to be the same as cash, Judge Holmes explains that it cannot change the actual payment rule that is so well embedded in tax law. “We don’t need to review Oklahoma law because what constitutes delivery of a check made in settlement of a federal lawsuit brought by the federal government is, we hold, a matter of federal, not state, law.”  Op. at 7.

Bottom line: to deduct a payment, ya gotta actually make the payment.

Coda:  Judge Holmes indirectly suggests that the payment might well be deductible under §162.  The IRS had said it was not deductible because §162(f) prohibits deductions for fines or similar payments and the lawsuit brought by HUD sought double damages.  The IRS sought to hit the Gages with an accuracy-related penalty and in the course of discussing that issue Judge Holmes points out that HUD was seeking to recover over $4 million and the entire settlement was for $1.75 million.  So it seemed a reasonable position for the Gages to take that the no part of their payment was punitive.

Comment:  I invite comments on whether the Gages could have or should have filed a protective claim for refund for 2013.  Would they have learned about the problem in time to do that?  They filed their Tax Court petition on November 11, 2017.  Does that suggest that they would have learned about the IRS’s concern over timing before April 15, 2017?  I would think filing an amended 2013 return claiming the deduction would have been important to do.  I invite comments on that from real tax practitioners.  I'm just an academic.  

Bryan Camp is the nerdy George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return each Monday (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.