Cummings v. Commissioner
506 F.2d. 449 (2d Cir. 1974)

  • In 1961, Cummings bought some stock in MGM and became a member of the Board. The stock went up and he sold it for a hefty profit. He reported the profit as a capital gain when he filed his 1961 taxes.
  • In 1962, the SEC noticed that there were some irregularities with Cummings actions. In order to avoid an investigation, Cummings returned the profits he made on the stock sale to MGM.
    • Cummings argued that he returned the money to protect his business reputation.
  • When he filed his 1962 taxes, Cummings treated the repayment as a deduction against his ordinary income. The IRS disagreed and assessed a deficiency.
    • The IRS argued that since Cummings paid taxes on the profits as a capital gain, he could only count the repayment as a capital loss,
    • Cummings argued that he returned the money to protect his business reputation. Therefore it was a business expense and should be deducted against ordinary income.
  • The Tax Court found for Cummings. The IRS appealed.
  • The Appellate Court reversed and found for the IRS.
    • The Appellate Court looked to to Arrowsmith v. Commissioner (344 U.S. 6 (1952)) and found 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.
    • Cummings argued that he had never been required to pay the money back, so Arrowsmith shouldn't apply. He wasn't paying the money back per se, he was just paying money to protect his reputation, so the money he was originally taxed on wasn't the same money that he later paid to protect his reputation. However, the Court didn't buy that argument.
  • The Arrowsmith Doctrine says that financial restorations associated with prior income items take the same tax "flavor" as the prior income items.