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
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
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
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
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
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