Arrowsmith v. Commissioner
344 U.S. 6 (1952)

  • Arrowsmith and another guy were co-owners of a corporation. They decided to go out of business and sell off the corporation's assets.
    • At the time the corporation was being sued for something or other.
  • When they filed their taxes the two guys properly counted the money they received from selling the assets as capital gains (which required them to pay less taxes than if it had been ordinary income).
  • A few years later, a court finally gave a judgment against their corporation that required the two guys to pay a settlement.
    • That's known as transferee liability.
  • When they filed their taxes, the two counted the amount they had to pay for the settlement as an ordinary business loss. The IRS disagreed and assessed a deficiency.
    • The two argued that if the corporation had still been in business, the money paid for the settlement would be considered an ordinary business loss. Since they were now responsible for the corporation's liabilities, they should also be allowed to claim the same thing.
      • They also argued that in the year of the correction, they didn't buy or sell anything (aka engage in a capital exchange), so how could any capital gains or losses possibly apply to them?
        • Remember, everything is treated as ordinary income unless there is an explicit provision saying it isn't.
    • The IRS argued that since the two paid tax on the corporation's assets as a capital gain, now that they had to give some of that money back, they should only be allowed to claim a deduction as a capital loss.
      • Remember, an ordinary business loss will result in a greater tax benefit than a capital loss.
  • The Tax Court found for the two guys. The IRS appealed.
  • The Appellate Court reversed. The two guys appealed.
  • The US Supreme Court affirmed and found that the payments were only deductible as a capital loss.
    • The US Supreme Court found that the two guys' liabilities was not based on any ordinary business transaction of theirs, but only because they were the transferees of the corporation's assets.
    • The Court noted that had the judgment been paid in the same year that the two guys split up the corporation, then the payments would have diminished the capital gain that the two guys received.
      • Basically it would have been a capital loss.
    • The Court found that a capital loss is not transmuted into an ordinary business loss just because each tax year is separate unit for tax accounting purposes.
  • Basically, this case said that if money was taxed at a special lower rate when received, the taxpayer would get an unfair tax windfall if repayments were deductible from receipts taxable at the higher rate applicable to ordinary income.
    • The Arrowsmith Doctrine says that financial restorations associated with prior income items take the same tax "flavor" as the prior income items.