The Sixteenth Amendment & the Issue of State Sovereignty

Sixteenth Amendment Income Tax State Sovereignty
The Sixteenth Amendment

In the next several installments of Huddleston Tax Weekly, we will discuss in great detail some of the controversies which were stirred by the sixteenth amendment. As we’ve noted in previous installments of HTC, the sixteenth amendment to the U.S. Constitution was an act of awesome importance. Through this amendment, the Congress was freed of the various constraints on its taxing power which had existed since the founding of the country. The original U.S. Constitution expressly gave Congress the power to tax, but it also set certain restrictions on this taxing power; excise (indirect) taxes had to be uniformly imposed, and direct taxes had to be properly apportioned among the several states. Prior to the sixteenth amendment, judicial opinions on tax law often dealt with determining whether a given tax should be classified as either direct or indirect. The sixteenth amendment removed the necessity of making such determinations.

The full text of the sixteenth amendment is as follows: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” Clearly, this amendment was directly responsive to a number of judicial decisions which, through their treatment of certain forms of taxation, had curtailed the taxing function of Congress. For instance, the Pollock case ruled that taxes on income derived from real property and personal property (such as stocks and bonds) were direct and therefore subject to the apportionment requirement. Pollock and other judicial opinions made the imposition of a federal income tax a practical – though not theoretical – impossibility. By removing the apportionment requirement, the sixteenth amendment made the implementation of such a tax an exceedingly simple matter.

The potential impact of the sixteenth amendment on state sovereignty was an issue immediately recognized by both the legal profession and the political establishment. Since it allowed Congress to collect taxes on incomes from any conceivable source, it apparently encompassed state securities; and by taxing state securities the Congress would be effectively lessening the power of the states in relation to the federal government. In his 1919 essay entitled “Power of Congress to Tax State Securities Under the Sixteenth Amendment,” Albert Ritchie argued that the amendment did not actually extend to state securities because the amendment was never intended to grant any new taxing powers to the Congress; the amendment was merely designed to consolidate Congress’ existing taxing powers, and since the power to tax state securities had historically been considered unconstitutional, and the authors of the amendment were themselves wary of the taxing of state securities, it follows that the amendment could not have granted a new power to tax state securities.

At the time of its publication, this essay by Mr. Ritchie must’ve had a great appeal. If taken solely on its words, the sixteenth amendment undoubtedly encompassed state securities, and it certainly raised the sovereignty of the federal government in relation to the states. But Mr. Ritchie’s reasoning involves looking behind the plain text of the amendment and considering the larger historical context in which this amendment was birthed. Given the conclusions to which it led, this reasoning certainly would’ve found plenty of open ears in 1919.

But Mr. Ritchie’s argument had at least one major weakness: it failed to recognize that the limited nature of state sovereignty has always been an established constitutional principle. As Mr. Harry Hubbard pointed out in his Harvard Law Review article entitled “The Sixteenth Amendment” in 1920, there is no constitutional basis for the notion that either the states or the federal government must have a certain degree of sovereignty. The Constitution provides that state sovereignty may be reduced if the people so desire with the power of amendment. The only principle which cannot be amended is the right of each state to have equal political representation. Thus, if the states choose to enlarge the role of the federal government through a constitutional amendment there is no higher authority which can be invoked to bar such a choice.

Mr. Hubbard argued that, given this reality, the sixteenth amendment was intended to cover state securities. The text did not need to specifically mention state securities in order to address any sort of historical trend against this type of taxation; if the amendment reduced state sovereignty simultaneously at the time that it consolidated Congress’ taxing power then this would have been a natural extension of the will of the people. We may like to suppose that, past a certain point, state sovereignty may not be encroached upon. But there is actually no constitutional foundation for this supposition. State sovereignty may be an ideal, but it is not unassailable and is very much subject to transformation depending on the whims of the public. In the end, the authors must have been aware of the amendment’s impact on state sovereignty, and it follows that any reduction in state sovereignty was fully permissible because these authors were merely acting as instruments of the people.

References

Hubbard, Harry. “The Sixteenth Amendment.” Harvard Law Review, Vol. 33, No. 6 (April, 1920), 794-812.

Ritchie, Albert C. “Power of Congress to Tax State Securities Under the Sixteenth Amendment.” American Bar Association Journal, Vol. 5, No. 4 (October, 1919), 602-613.

Pollock v. Farmers’ Loan & Trust Co., 157 U.S. 429 (1895)

Hylton v. United States, 3 U.S. 171 (1796)

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Mercantile Trust Co. v. Commissioner & the Limited Importance of Contingencies

Real Estate Property Transaction Exchange
Real Property Exchange

Nearly every legal concept presently in use in these United States has an established pedigree. Very few of our concepts are recent inventions. This observation holds true not just in one or two areas of law but for quite literally our entire legal edifice. Section 1031 is no exception to this rule. Section 1031 is derived from a number of earlier tax acts which addressed the non-recognition of gains (or losses) when real property held for business or investment purposes is exchanged for like-kind property. Today, courts utilize the judicial opinions made in previous eras which were informed by one of these earlier tax acts. The case of Mercantile Trust Co. v. Commissioner (1935) is among the most significant of these opinions.

As we will see, Mercantile Trust Co. set an important precedent for viewing complex real property exchange transactions. Like the parties in Alderson v. Commissioner, the parties of Mercantile Trust Co. engaged in a complex transaction which involved multiple independent contracts, the use of an intermediary and a cash payment as “boot” on top of the exchange. In its opinion, the court emphasized that non-recognition depends primarily on what actually occurred, rather than on the various methods and motives which ultimately led to the transaction. Simply because a contingency could have given rise to a sale – and therefore would have created a taxable gain – does not necessarily bar non-recognition; the most important fact is whether an exchange of like-kind property actually transpired.

Facts

The representatives for Mercantile Trust Co. (the petitioners) appealed a judgment for a tax deficiency arising from a transaction involving Mercantile Trust Co., an intermediary (known as Title Guarantee & Trust Co.) and Emerson Hotel Co. The Commissioner of Internal Revenue (the respondents) claimed that the transaction amounted to a sale and that the petitioners had a recognized gain of $179,621 (approximately $2,521,070.02 when adjusted for inflation in 2016). The petitioners argued that the transaction had been an exchange of real property of like-kind within the scope of existing statutory provisions.

Title Guarantee & Trust Co., the intermediary, developed separate contracts with Mercantile and Emerson. To conclude certain of these contracts Title Guarantee made cash payments to the other party, and to conclude other contracts Title Guarantee accepted cash payments. Mercantile Trust Co. ultimately received the deed to the property (known as Lexington Street) originally held by Emerson Hotel Co. as well as a total of $24,426.90 in cash. Emerson Hotel Co. received the deed to the property originally held by Mercantile Trust Co. (known as Baltimore Street). Title Guarantee received commissions and title fees which added up to $8,573.10.

The respondents assessed the tax deficiency on the premise that Mercantile Trust Co. acquired the Lexington Street property in a separate transaction which should be considered a sale. The question before the court was whether the evidence on record supported this premise.

Law

The statutory provisions which applied to the case arose from section 112 of the Revenue Act of 1928. Section 112 (of the act of 1928) is the predecessor of section 1031 and includes many of the same provisions as the current law.

Ruling

The court (the U.S. Tax Court, known as the Board of Tax Appeals in 1935) ruled in favor of the petitioners and declared that the deficiency assessed by the Commissioner was without basis. The Commissioner argued that what had occurred was a “fictitious” exchange and that the Lexington Street property was acquired by Mercantile Trust Co. in an independent sales transaction. The tax court rejected this argument. The contract made between Mercantile Trust Co. and Title Guarantee included a contingency whereby Title Guarantee would pay $300,000 in cash in the event that the deed to the Lexington Street property could not be transferred. The court determined that this contingency did not negate non-recognition treatment given that an exchange of like-kind property did occur.

The reasoning employed by the tax court in Mercantile Trust Co. influenced later decisions, including the decision made in Alderson. The determination of non-recognition treatment depends heavily on the end result and not as much on the methods used to reach that result.

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Readers who enjoyed this piece about the famous case of Mercantile Trust Co. should check out our video on the tax perks of real estate ownership given by CPA Jessica Chisholm

Starker v. United States & the Qualifications of Internal Revenue Code Section 1031

Real Estate Property Capital Gains Section 1031
Real Estate Investment

Every real estate owner and investor should take the time to become acquainted with the elements of section 1031 of the Internal Revenue Code. This section allows taxpayers to defer recognition of either gain or loss when they exchange property of like-kind with another party. For any number of reasons, it may be wise for an owner or investor to exchange their property for another. Sans 1031, an exchange of real property would necessarily involve the realization of either gains or losses, and the management of such realization would require substantial investments of time and money. Section 1031 promotes a more open and free marketplace by eliminating the burdens which traditionally follow real estate sales.

Because of the heavy benefits it confers, section 1031 has rigid qualifications which are narrowly construed by courts. One case which illustrates the narrow reading of section 1031 qualifications is Starker v. United States (1977). As we will see, the plaintiff in this well-known case attempted to expand the construction of section 1031 so as to include a complex, multiyear financial transaction in which he took part. The court rejected the plaintiff’s attempt and set a precedent for a narrow construction of 1031.

Before hearing Starker, the court had just settled an earlier case, known was Starker I, which was heard in 1975 and involved the son and daughter-in-law of the plaintiff of the 1977 Starker case. The plaintiff’s son and daughter-in-law had also taken part in the same transaction which formed the basis for the suit of 1977; like the plaintiff, they tried to receive non-recognition of their capital gain under section 1031. The judge in Starker I concluded that the son and daughter-in-law correctly invoked section 1031 and were therefore entitled to a refund for taxes paid on the transaction. The next Starker case was heard by the same judge; this judge reconsidered his earlier decision and ruled against the plaintiff. As we’ve noted before, sometimes no amount of preparation can account for the whims of our magistrates.

Facts

The plaintiff transferred a very large amount of land – approximately 1,843 acres – to a company known as Crown Zellerbach Corporation. In return, the company created an “exchange value” balance on its books. To reduce the balance, the company was supposed to transfer a number of parcels of land to the plaintiff; as part of the agreement, these parcels did not need to be transferred all at the same time, but could be transferred one by one over the course of several years. Collectively, these parcels were supposed to be equal in value to the land given to the company by the plaintiff. The plaintiff also received a “growth factor,” which was interpreted as a type of interest by both the company and the court.

The plaintiff invoked section 1031 when filing the income tax return which included this transaction. The IRS denied this invocation and assessed a tax deficiency of $300,930.31 plus interest. The plaintiff then brought a suit to receive a refund.

The question before the court was whether the plaintiff was in fact entitled to non-recognition under section 1031 given the peculiar characteristics of his exchange.

Law

Under section 1031 of the Internal Revenue Code, taxpayers are entitled to non-recognition of capital gains or losses which arise from the exchange of property of like-kind. The exchange must be reciprocal and involve a present transfer of ownership; it cannot involve a promise to transfer property in the future.

Ruling

The court disallowed section 1031 and ruled in favor of the government. The court rested its decision on a number of factors. One factor was the element of time: the parties did not simultaneously exchange property of like-kind, but instead created a balance which was to be paid off incrementally over a period of time. And in the event that the parcels of land given to the plaintiff did not settle the balance after a period of five years, the agreement between the plaintiff and company held that the company would then transfer cash to cover the remainder. What’s more, two properties transferred by the company were not actually given directly to the plaintiff; the properties were given to the plaintiff’s daughter. And on another occasion, the plaintiff did not specifically receive the title to a property, but was given cash equal to the purchase price of the property along with the company’s right to acquire the property. These and other factors combined to provide a foundation on which the court made its decision to deny non-recognition treatment.

More than anything, our readers should use the Starker case to see the limited availability of section 1031. Where Starker applies, it can be an incredibly useful tool, but know that it only applies in scenarios which explicitly fall under its requirements.

In our upcoming installments, we will look at sections 1033 and 121 and highlight how these sections can also be of use to taxpayers.

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To learn more about the tax benefits of real estate ownership, please view our presentation by CPA Jessica Chisholm

Hawaii Housing Authority v. Midkiff & the Function of Eminent Domain

Law Market Economics Eminent Domain Property
Eminent Domain

One of the most enduring myths about government in the United States is the idea that governmental behavior is more or less congruent with standards of individual morality. In other words, most Americans believe that government authority is shaped and ruled by the same moral standards which shape and rule the behavior of the average individual. Governmental behavior may have special leeway in a few instances, but for the most part it is constrained by the same principles which constrain the typical man on the street.

This idea, while not without foundation, falls well short of capturing the truth. What most people do not realize is that governmental morality is based on processes which are altogether different from those which form the basis for the morality of the individual. Individual morality is based on reciprocity, the classic notion of “give and take”: we refrain from damaging our neighbor’s property or stealing goods from our friends because we expect this same kind of treatment in return. Individual morality is an exchange, it stems from the basic idea that whatever action or inaction we take will be reciprocated by whoever is affected.

And because our government is nothing other than a massive collection of individuals, many people assume that governmental behavior must be based on this same principle. In reality, however, this is not the case, because our government does not take part in the sort of interactions in which the individual takes part. Instead of reciprocity, government behavior is based on reason, it derives from a wholly rational process involving the weighing of pros and cons and the careful analysis of possible outcomes. A good deal of the confusion about government would quickly disappear if this fact were realized.

There are various ways to show that this is an accurate statement; today, we will use the concept of eminent domain to prove our case. Relatively few property owners are aware that the government has the constitutionally conferred power to confiscate private property, and that the exercise of this power is not limited strictly to times of war. Denuded of its lofty name, eminent domain is simply a forcible acquisition of the sort which would be punishable if committed by an individual citizen. Of course, this does not speak to its propriety, but only illustrates the fact that governmental behavior operates according to different rules. Let’s take a peek at the case of Hawaii Housing Authority v. Midkiff (1984) to get a sense of the contours of eminent domain.

Facts

On the island of Oahu, 22 landowners held 72.5 percent of the land titles. This oligopoly led to a distorted market which involved inflated prices and general social discontent. One landowner (the Bishop Estates) held an unusually large portion of land. The Hawaii Legislature passed a measure designed to redistribute the lots held by the Bishop Estates to their corresponding lessees. The legislature reasoned that this transfer of ownership was in the best interests of the entire community. The measure was brought before the Supreme Court of the United States in order to determine its constitutionality.

Law

The doctrine of eminent domain arises from the Fifth Amendment to the U.S. Constitution. According to the so-called “public use doctrine,” the government has the ability to transfer title of ownership if such a transfer serves a legitimate public good.

Ruling

In an 8-0 (unanimous) decision, the Supreme Court of the United States ruled that the measure adopted by the Hawaii Legislature was constitutionally valid. The court’s decision of this case was significant because the legislature did not transfer the title of the land to the “public,” but to a larger share of private homeowners. However, though this was the case, the court determined that the legislature’s invocation of eminent domain was valid because the correction of the market conferred a substantial benefit to the general public. In other words, in order for eminent domain to be invoked, private land does not have to be put specifically to public use; it only has to confer a clear benefit to the wider populace.

Of course, circumstances will rarely compel the typical homeowner to master the finer points of eminent domain; but it is still important for virtually every homeowner – and nearly every citizen, for that matter – to have at least a basic understanding of this concept. As citizens, we have to be aware of all the functions of our government, not just those which are the most visible or common. Eminent domain may not dominate the headlines of our most popular media, but as we’ve seen it is still remarkably important.

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In addition to a knowledge of eminent domain, our readers who own property will also benefit from the following presentation about the tax advantages available to homeowners

Mannillo v. Gorski: The Case of the Intrusive Neighbor

Property Law Adverse Possession
Property Law

Most aspiring homeowners understand that owning property involves a great deal of responsibility. When you own property, all of the maintenance and liabilities which would otherwise be taken care of by a landlord are absorbed by you. A leaky faucet, faulty drain or unstable foundation is no longer someone else’s obligation. Usually, the responsibilities of homeownership are fairly mundane and do not place an extreme level of stress on homeowners. Every now and then, however, homeownership presents a unique problem which demands an inordinate amount of attention and energy in order to fix. The case of Mannillo v. Gorski (1969) is one example of such a problem.

Facts

Gorski (the defendant and appellant) acquired possession of a piece of land in 1946. Mannillo (the plaintiff and respondent) possessed a piece of land which was adjacent to Gorski’s land. Gorski’s son made various improvements to Gorski’s property in the summer of 1946. One of these improvements encroached upon Mannillo’s property. The encroachment was quite small and was not easily visible to the casual observer. By the time Mannillo decided to bring a suit against Gorski in order to remove the encroachment, the statutory period of time required for adverse possession had been satisfied. Gorski argued that he had lawfully gained title to the disputed land because his encroachment satisfied both the element of time as well as the other statutory requirements of adverse possession.

The question before the court was: did Gorski gain title to the disputed section of land by way of adverse possession according to the state (in this case, the state of New Jersey) statute?

Law

In order to gain title by way of adverse possession, the possession must be exclusive, continuous, uninterrupted, visible and notorious, and it must satisfy the statutorily defined period of time.

Importantly, the court in Mannillo v. Gorski determined that there need not be an element of knowing intentional hostility on the part of the adverse possessor. Though an earlier court opinion held that such a mental state was required, the court in Mannillo v. Gorski concluded that such a state was unnecessary.

Ruling

The court (the Supreme Court of New Jersey) remanded the case and ordered a new trial. Mannillo had succeeded at the trial court level because the trial court included intentional hostility as part of the requirements for adverse possession. And Gorski had actually been under the impression that the disputed section of land was within his territorial boundary, and so clearly the encroachment could not be said to be knowingly hostile. The Supreme Court threw this requirement out.

However, the court found that Gorski’s encroachment did not necessarily satisfy the requirements of adverse possession because the encroachment was so minor as to be practically unnoticeable without focused scrutiny. In cases involving a minor encroachment across adjacent properties, the true owner must have actual knowledge of the encroachment in order for the requirements of adverse possession to be met. The court ordered the new trial to utilize this updated standard.

Clearly, the facts of Mannillo v. Gorski are not likely to be replicated very often; but Mannillo v. Gorski is still something homeowners should be aware of because it illustrates the sort of bizarre difficulties which can occasionally arise during the course of homeownership. Again, if you own property, you probably will not experience what Mr. Mannillo experienced, but it is still important to be aware of even the most unlikely possibilities.

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If you’re a homeowner and you’d like to learn more about the tax benefits which arise through property ownership, view the following webcast presentation by our resident CPA Jessica Chisholm

The Tariff Which Shook History

Tariff Rate Act Morrill Tax
Morrill Tariff

As has been noted previously, substantive changes in tax policy are often closely tied to big changes in the social order. And the tie is not unidirectional, resulting solely from a tendency for tax measures to provoke heated reaction from a population. Sometimes a social change – such as a war – can massively alter the tax policy of a state. In the historical process, tax policy is both an active agent and a reactive agent, both a cause and an effect.

In most cases, it is not too difficult to determine the impact which a change in tax policy has had on society. The assessment of most changes is rather straightforward. The Morrill Tariff of 1861 – named after its sponsor, Vermont politician Justin S. Morrill – stands out among tax law because it defies this trend: although there can be no argument against its general importance, there is considerable controversy as to its specific role in history. Historians are divided as to what role the tariff act played in furthering the secessionist sentiment among Southern states: was the tariff a point of only minor irritation for Southern states? Or was it a matter of major frustration which caused Southern states to view secession as a necessary solution rather than a possibility?

The thing which is certain about the Morrill Tariff is that it raised rates substantially. In the years just preceding the Morrill act, American tariff rates had been unusually low by global standards. Between 1857 and 1860, the U.S. had average rates of approximately 17 percent overall and 21 percent on dutiable items. By 1865, the Morrill Tariff had increased these rates to 38 percent and 48 percent, respectively. Aside from bringing U.S. rates closer to global averages, the Morrill act also provided means to ameliorate the financial woes plaguing the U.S. Treasury.

Support for the Morrill act tended to vary according to political and sectional affiliation. The vast majority of Republicans voted in favor of the act and the clear majority of Democrats opposed it; there was an unmistakable sectional division as well, with every lawmaker from the Southern states except one voting against the act.

Historians who believe that the Morrill Tariff played only a minor role in furthering sectional hostility emphasize the element of time in the adoption of the act. The development of the tariff had begun well before any state had seceded from the union, but not until several states had withdrawn was the tariff act able to succeed in Congress. Historians point to this fact and infer that the tariff had only minimal significance given that a number of states had already decided to secede.

However, on the other side of the issue, historians emphasize that tariff revision had been a heated topic of discussion well before any state declared secession. The South had a clear interest in embracing free trade given the nature of its economy; Southerners also generally felt that they lacked the proper representation in the federal government which was necessary to ensure an equitable outcome. What’s more, the Morrill Tariff was mentioned specifically as a source of displeasure by the conventions of both Georgia and South Carolina; the tariff was even discussed in South Carolina’s secession ordinance.

The precise role of the tariff in promoting secession (and ultimately the War Between the States) will likely be debated for many years to come. Both sides of the matter have facts on which to rest their case; about which there can be no debate, however, is the fact that the tariff must be regarded among the most consequential in U.S. history.

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Armory v. Delamirie & the Evolution of Property Rights

Property Possession Right Law Priority
The Property Right of Possession

The evolution of our law is truly an amazing phenomenon. It is equal parts humbling and awe-inspiring to contemplate that many foundational legal concepts trace their origin to cases which occurred hundreds of years ago. To the casual observer, it may seem as though our law emerged just recently all at once as a finished product, the miraculous outcome of one act of divine intervention; in actuality, our system has come about through an exceedingly slow, gradual process of revision and refinement transpiring over the course of many centuries.

Take, for example, the very basic idea that a person who finds an object establishes some type of claim of ownership to the object. Colloquially, this principle is referred to as the rule of “finders, keepers.” This simple notion was not created by an American jurist, nor was it created within living memory. In point of fact, this idea first acquired legal significance through the famous English case of Armory v. Delamirie which was heard in 1722. Armory formally established the principle that a finder acquires a form of legal title by way of possession.

Facts

Armory (plaintiff) was the helper of a chimney sweep. While on the job, he found a jewel composed of gems embedded in a ring. Armory took the jewel to a goldsmith (Delamirie, the defendant) to have it appraised. The goldsmith’s apprentice took the gems from the ring so as to weigh them separately. The apprentice gave Armory an estimation of their value and then returned the ring without the gems. The apprentice made an offer for the jewel but Armory declined. Armory demanded that the gems be returned inside the sockets of the ring in the same condition as when they were initially brought to the goldsmith’s shop. The apprentice did not comply – presumably on the excuse that he “lost” the gems – and subsequently Armory brought a suit against the goldsmith (via respondeat superior) for the return of the jewel.

The issue before the court was whether Armory had a superior title to the jewel despite the fact that he was not the true owner. That is, whether the title he acquired through finding the jewel was sufficient to warrant the return of the jewel from the goldsmith.

Law

In the hierarchy of ownership, the present possessor (or finder) has a superior title against everyone except the true owner.

Ruling

The court (The Court of King’s Bench) ruled in favor of Armory. Since he found the jewel, Armory’s title was superior to all but the true owner; and since the true owner was unknown this effectively gave Armory true ownership. The court ordered Delamirie to pay Armory for the jewel at the highest possible estimation of the jewel’s value in the absence of any contradictory evidence as to the jewel’s value.

The importance of possession in acquiring property rights was understood prior to the case of Armory v. Delamirie; in fact, the rule of “finders, keepers” has existed in some form since ancient Rome. But it was Armory which caused this old idea to be codified in our common law. The fact that our common law was heavily impacted by a chimney sweep helper’s stroke of good fortune is nothing less than remarkable.

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Readers who enjoyed this piece should view our presentation on the tax savings available to real estate owners given by our CPA Jessica Chisholm

Thought of the Day: What’s in a Tax?

What’s in a tax?

Divested of all misleading associations and stripped of any false labels, what does a tax truly represent?

Tax History Policy Interest Taxation
Tax Policy

In these last several months, Huddleston Tax Weekly has covered a wide range of topics. We’ve looked at tax measures from eras far removed from our own: we’ve examined the Tea Act which fueled our revolutionary fervor; we looked at the tax acts passed by the Confederacy in its struggle against the North; we even covered the geld, a medieval tax which provides a glimpse into the formation of the English nation. We’ve also touched on topical issues, such as Apple’s EU tax bill and the tax instituted in Vancouver designed to stabilize the real estate market. Our treatment of these many issues has vastly increased our understanding of the role of taxes in history and in our current society.

If there were a single lesson to be drawn from all of the many issues we have covered in these recent months, the lesson would be: tax policy is shaped by the competing interests of distinct groups. Taxes are not developed through a completely rational process in which the interests of every relevant group are considered carefully; in a very real sense, taxes are developed through a competitive process, and the end result usually involves certain groups having a more favored position than others. This is not the most pleasant revelation, but it is one which accurately reflects reality. It may do more to serve the ego of our society to suppose that tax policy is strictly the outcome of reasoned, sensible debate among lawmakers, but this does not mean that such a supposition is any reflection of the truth.

Of course, there are undoubtedly plenty of other lessons to be drawn from the issues we have discussed, and in future installments of Huddleston Tax Weekly we will do our best to cover these lessons. But for now, it is important to understand what taxes represent at a very basic level. Behind all the number crunching, the box checking, the empty bureaucracy, the abstruse terminology and the lofty rhetoric, a tax is a tool utilized to further the interests of a particular group. A tax can be created for any number of reasons: a tax may be used to generate funds for war; a tax may be implemented in order to stabilize a specific market; or a tax may be forcibly imposed by an occupying entity, as was the case with the geld. But no matter what the reason is for its creation, it is clear that any given tax is an extension of a specific interest group.

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United States v. Winthrop & the Test for Ordinary Income

Investment Property Real Estate Land Capital Gain
Investment Property

In our earlier article about the case of Byram v. United States (1983), we introduced the 7 pillars of capital gain treatment and discussed the recurring issue of distinguishing business sales from investment sales. In Byram, the court found the profits of multiple real estate transactions to be capital gains due to the peculiar facts which surrounded the transactions. In this article, we will discuss the specifics of an earlier case – United States v. Winthrop (1969) – in which the court rejected the capital gain classification and ruled that certain transactions were sales made in the ordinary course of business.

It is important that our readers have an understanding which is as clear as possible of what constitutes a capital gain so that they can avoid any unpleasant surprises. The facts of United States v. Winthrop contribute toward this understanding.

The case of United States v. Winthrop will also give readers a sense of the unpredictability in judicial reasoning. Prior to being heard by the Fifth Circuit Court of Appeals, the facts of this case were found to support a capital gain classification at the trial court; the Fifth Circuit actually had to overturn this finding to reach its conclusion. And given that there was no dispute between the trial court and appellate court over any matter of fact in the case, and that there were multiple potentially compelling cases cited by Winthrop, it follows that the outcome of even a strongly backed case cannot be predicted with mathematical certainty.

Facts

Over the course of a number of years, Mr. Winthrop (respondent in appellate case) inherited several pieces of real estate. Collectively, these pieces were referred to as “Betton Hills.” Mr. Winthrop inherited his first piece of land in 1932, and he began to develop that same piece a few years later in 1936. Mr. Winthrop inherited additional pieces of land at various other dates (1946, 1948 and 1960).

In 1936, Mr. Winthrop made his first sale by selling a portion of the land he had began developing earlier that same year. Mr. Winthrop continued to develop his land and sell portions of it to interested buyers up until his death in 1963. Hence, his sales operation spanned multiple decades. Though he did not create a business office, he devoted massive amounts of energy to developing the land so as to make it more marketable. What’s more, the income derived from real estate sales constituted the majority of his entire income for many years prior to his death. Mr. Winthrop also began to include “real estate” as his occupation for a number of years in official documents before his death. The question before the court was: should Mr. Winthrop’s activities receive capital gain treatment given the facts which underlay them?

Law

There are a number of common law tests which have been developed to aid the court in its determination of capital gain treatment. Though this is true, the court must also be certain to view each case as an independent matter and provide each case with its own analysis.

In United States v. Winthrop, there was no disagreement made by the Fifth Circuit regarding the fact that the land was held “primarily for sale” by Mr. Winthrop. The only remaining issue was whether the sales executed could be classified as sales made in the ordinary course of business. The Fifth Circuit stated that the ordinary course of business determination depends on whether selling the land was Mr. Winthrop’s primary purpose in holding the land.

Ruling

The Fifth Circuit overturned the trial court’s finding and determined that the sales made by Mr. Winthrop were made in the ordinary course of business and therefore should be disqualified from capital gain treatment. Mr. Winthrop clearly had a reasonably strong case given that he did not actively and aggressively advertise his properties, he did not maintain a sales office, did not reinvest his profits in other real estate (for the purpose of growing his business) and he initially acquired the real estate through inheritance rather than purchase. There were certainly many facts capable of supporting his position. Ultimately, the fact that Mr. Winthrop only used the properties for the purpose of selling to customers proved to be decisive.

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A Note on the Capital Gains Tax

Capital Gains Tax Rate Money Funds
Capital Gains

As the previous installment of Huddleston Tax Weekly made clear, our tax code draws a distinction between ordinary income and capital gains. In general, ordinary income is income derived throughout the course of running a business or trade; capital gains result from the sale of a “capital asset” (which is defined by the code). It is important for people to understand how their behavior will be classified because these classifications carry particular tax implications. In conjunction with criteria from the tax code, our common law also provides additional guidelines for classifying a given source of income.

The capital gains tax has long been the focus of controversy: many argue that its current low rate disproportionately benefits wealthy citizens and that it should be increased, while others contend that a lower rate actually stimulates more economic growth and that such growth benefits citizens of all socioeconomic levels. The evidence in favor of the latter position is considerable and should strike most objective observers as persuasive. The capital gains tax rate has fluctuated widely over the past several decades, and there is an unmistakable positive correlation between low rates and greater revenues generated from capital gains. This association may appear counterintuitive upon first glance, but a bit more scrutiny makes it very easy to understand: when the tax rate is high, people simply hold on to their assets and avoid paying the tax at a high rate; when the rate is low, people sell more frequently and this results in greater total revenues for the government.

Low rates also appear to influence stock market prices. The tax cuts in the 1980s, the late 1990s, and in 2003 all coincided with significant stock market gains. What’s more, there is also an association between reduced rates and business development as measured by initial public offerings (IPOs), money raised from IPOs and the money committed to venture capital firms. Investors are less willing to commit funds when capital gains tax rates are high; this agrees with common sense given that higher rates will result in smaller returns on investment.

Though lower capital gains tax rates do appear to provide greater benefits to the economy as a whole, there is no denying that such rates disproportionately benefit higher income levels. The clear majority of gains from capital asset sales are made by those with incomes above $200,000. Going forward, it appears that the debate on capital gains tax rates will be framed by this question: can our society accept the positive impact of lower rates even though lower rates tend to benefit wealthy individuals disproportionately?

References

Moore, Stephen. “Capital Gains Taxes.” David R. Henderson (ed.). Concise Encyclopedia of Economics. Indianapolis: Library of Economics and Liberty.

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