THE BURGESS/BATTLESTEIN SCENARIO: A PAYMENT VERSUS A PROMISE TO PAY

THE BURGESS/BATTLESTEIN SCENARIO: A PAYMENT VERSUS A PROMISE TO PAY A taxpayer may not pay an amount with funds borrowed from the creditor immediately prior to the attempted payment. 1 A taxpayer, however, may borrow funds from a third party and then effectuate a payment using those funds. Economically, the two transactions are identical. Legally, however, they are different. Under the Burgess decision, a taxpayer may borrow from a creditor, commingle the funds with other funds, wait some period of time (see THE OLD AND COLD DOCTRINE) and then successfully pay the creditor/lender. The element of payment is essential to the cash method of accounting: without it, an expense is not deductible. Similarly, under section 461(h), some accrual method expenses are non-deductible until "paid." Also, some code sections such as section 170, dealing with charitable contributions require "payment" regardless of the taxpayer's accounting method. Exactly what constitutes a payment, however, is disputable. Contrasting a mere promise to pay with an actual payment can be particularly trying. As do many difficulties in the U.S. tax system, this problem stems from the treatment accorded borrowed money. In general, the source of funds used to pay an expense is irrelevant to the allowance of a deduction. Hence, a taxpayer may borrow money from Peter to pay Paul and, as a result, generate a deduction even though he has not yet paid anything from his own funds. In a system that recognizes borrowed funds as generating basis - such as resulting from the Crane decision and its progeny - this rule is logical: no reason would exist to distinguish funds used to purchase property from those used to pay expenses. Also, tracing the source of funds used to pay an expense could result in accounting nightmares. Nevertheless, a system that relies on the cash method of accounting must have a rule distinguishing a payment from a promise to pay : a payment of Paul cannot be the same as a promised payment of Paul. Otherwise, the cash method would result in income recognition upon receipt and deduction recognition upon the earlier of payment or incurrence of the obligation. This would mix cash an accrual notions to the unfair benefit of taxpayers and to the detriment of the government: taxpayers could defer income until receipt (over which they have some control) but recognize deductions early, with no cash outlay. In contrast, a system that requires a true payment even with borrowed funds, limits a taxpayer s ability to manipulate the system by requiring a bona fide borrowing - generally from a third party - which itself has some real costs. 1 Battlestein v. Commissioner, 631 F.2d 1182 (5th Cir. 1980) (en banc). 2008 by Steven J. Willis. All Rights Reserved. 1

Still, two things present problems: 1. Money is fungible. As a result, well informed taxpayers can pay deductible costs and promise to pay capital items - and thus generate both a deduction and basis - when a switch of the two transactions would cause deferral of the deduction. That arbitrariness, however, is inherent in the cash method. Why? Because of the second problem. 2. The cash method itself is an arbitrary method of accounting that does not clearly reflect income. It is not consistent with generally accepted accounting principles and is permitted for tax purpose only because of its simplicity. The price of that simplicity is arbitrariness. Earning and owing are concepts that fundamentally reflect wealth and income. Receipt and payment are not. But earning and owing (critical to the accrual method) are difficult concepts which may require accounting expertise to apply. Receipt and payment are easy to visualize and simple to apply. Their arbitrariness and lack of accuracy are probably a reasonable price to pay for their simplicity. Part of that arbitrary price is the necessary line-drawing which results in the Burgess and Battelstein decisions, which draw that arbitrary line in an imperfect, but simple, system. A. Burgess v. Commissioner 2 Borrowing from Peter to pay Paul results in a payment. No one disagrees with that. Thus a taxpayer may borrow funds from First National Bank and immediately used them to pay a deductible amount to Second National Bank. But, in a reviewed opinion, with six dissents, the Tax Court held that a taxpayer, under some circumstances, may borrow from Peter to pay Peter and still satisfy a payment requirement. Facts: The year was 1941 and the cash method taxpayer owed $4,219.33 in interest to Archer & Company. On September 16, 1941, the taxpayer borrowed $3,000 from a trust company - unrelated to the Archer & Company - and deposited it into an account with the trust company. On December 22, 1941, the taxpayer borrowed $4,000 from Archer & Company, which it also deposited in the trust company account. On December 26, 1941, the taxpayer wrote a check on the trust account to Archer & Company in the amount of $4,219.33 to pay the interest owed. On that date the account contained $7,180.79, including the $4,000 borrowed from Archer & Company. Issue: Did the transfer of money to Archer constitute a payment of the interest? 2 8 T.C. 47 (1947). 2008 by Steven J. Willis. All Rights Reserved. 2

The government disallowed the interest deduction, asserting the item was not yet paid. As the court explained: The only controversy is whether the petitioner actually made a cash payment of interest to Archer & Co. in the total sum of $ 4,219.33, or only substituted his promise to pay for $ 4,000 of the amount due. 3 Holding: Yes, Burgess paid the interest. With six dissents, the Tax Court disagreed with the government and allowed the interest deduction, finding the transfer to be a payment. The court found several factors important: 1) the commingling of the borrowed funds with other funds in an existing account; The cash received by the petitioner from the proceeds of his $ 4,000 loan was commingled with his other funds in the trust company. 4 The situation in this case differs from that in John C. Cleaver, 6 T. C. 452; aff d., 158 Fed. (2d) 342, where the bank computed interest for five years on the principal amount of each note and deducted the interest so calculated from the principal amount of each note and made the balance available to the taxpayer. Obviously, the interest in the Cleaver case never went through the hands of the borrower and never passed through his bank account. Though representing interest, it was merely an addition to the principal sum and did not become deductible until the notes were paid. Here the facts differ substantially. 5 2) the multiple uses for the borrowed funds; The petitioner did not borrow $ 4,000 solely to pay his interest due to Archer & Co. This item was one of several bills due in December. 6 3) the time involved; and 4) the fungibility of money (described in terms of traceability): Its identity was lost and it could not be traced to the payment of the interest charge made in response to the notice of October 16, 1941. The petitioner made a cash payment of interest as such. He did not give a 3 Id. 4 Id. at 48. 5 Id. at 48-49. 6 Id. at 48. 2008 by Steven J. Willis. All Rights Reserved. 3

note in payment, as held by the respondent. Consequently, the interest payment of $ 4,000 disallowed by the respondent is properly deductible. 7 The relative importance of these four factors was not clear from the opinion. Also, the court did not say that all the factors were critical; instead, it merely said that with these facts a payment occurred. In Cleaver - with none of these four factors - a payment did not occur. Later cases have not provided much additional clarity; however, they have reiterated the distinction. For example, in 1975, the Tax Court restated the Burgess doctrine 8. The taxpayer deposited $1,000,000 of loan proceeds into his checking account and thereby comingled it with $42,009.02 of other funds. One day after the deposit, he made an interest payment of $377,202 to the lender. Again, despite a large part of the interest payment being clearly traceable to the loan, the Tax Court held, under the Burgess doctrine, the taxpayer had paid the interest for tax purposes. According to the Court's reasoning, the taxpayer had control over the proceeds and could have made the interest payment from other assets had he so chosen. B. Battelstein v. Commissioner 9 In this 1980 14 to 10 en banc opinion, the Fifth Circuit questioned the Burgess distinctions, adding its own gloss. Essentially, the court acknowledged that borrowing from Peter to pay Paul results in a payment. But, borrowing from Peter to pay Peter immediately does not result in a payment. Also, the court doubted whether the Burgess middle ground - borrowing from Peter, commingling the funds and waiting a few days, and then paying Peter - results in a payment. As a result, reliance on the Burgess factors is risky. To be safe, a cash method taxpayer should borrow funds from a third party to pay a deductible expense. Facts: The Battelsteins borrowed substantial funds from Gibralter Savings Association. Regularly, when interest was due, they sent a check for the interest. Upon receipt, Gibralter sent them a check - in the same amount - as a pre-arranged loan. Issue: Did the taxpayer pay the interest by the mere exchange of checks with the lender? Holding: No. The form of the transaction controls over the substance. While the form appeared to constitute a payment, the substance was merely a deferral of the interest payment until a later time. 7 Id. at 48. 8 G. Douglas Burck, 63 T.C. 556 (1975), aff d on other grounds 533 F.2d 768 (2d Cir. 1976). 9 631 F.2d 1182 (5 th Cir. 1980). 2008 by Steven J. Willis. All Rights Reserved. 4

Describing the exchange of checks as inconsequential, the court explained we merely follow a well-established principle of law, viz., that in tax cases it is axiomatic that we look through the form in which the taxpayer has cloaked a transaction to the substance of the transaction. 10 The majority distinguished Burgess by explaining that this case was critically different: even assuming that the Burgess cases constitute good law. In the Burgess cases, the Tax Court was faced with situations in which taxpayers had obtained first one loan and then another from the same lender, and then had attempted to claim a deduction for interest paid on the first loan, even though the interest was possibly paid with funds obtained as part of the second loan. Under the Code, a taxpayer may be entitled to a deduction in such a situation only if the second loan was not for the purpose of financing the interest due on the first loan. If the second loan was for the purpose of financing the interest due on the first loan, then the taxpayer's interest obligation on the first loan has not been paid as Section 163(a) requires; it has merely been postponed. In many cases, it is not apparent what the purpose of a subsequent loan was - whether it was to finance the interest payments on a previous loan for which deductions are being claimed, or whether it was to fulfill some other unrelated objective. In the Burgess cases, the Tax Court attempted to establish a formula to be used in making such a determination. The formula has been subject to criticism for being too easy to manipulate by taxpayers and thus as unduly inviting tax evasion. Whether or not this criticism is valid, it is clear that it is unnecessary to apply the formula here, or that if applied here in light of its purpose it could yield only one result. This is because the subsequent loans made by Gibraltar to the Battelsteins - the checks issued by Gibraltar to the Battelsteins as part of the check exchanges, in the exact amount of the Battelsteins' current interest obligations - were plainly for no purpose other than to finance the Battelsteins' current interest obligations to Gibraltar. 11 The dissent raised significant practical questions resulting from the arbitrariness of the majority opinion. For example, a taxpayer may pay deductible interest to his bank, using a check drawn on an account with overdraft privileges. If the account has insufficient funds, the bank will loan its customer funds with which to pay the check. This should not satisfy the Battelstein test; however, that failure may not be obvious to the bank or to the taxpayer. Whether this exchange would satisfy some or all of the Burgess factors is less certain. A bona fide account, with some commingling, and mixed purposes for the borrowing (if multiple overdrafts occur) would seem to exist. 10 631 F.2d at 1183. 11 Id. at 1184. 2008 by Steven J. Willis. All Rights Reserved. 5

Nevertheless, attacking the Battelstein rule as arbitrary and sometimes unfair does not undermine its necessity. The decision is the necessary result of an arbitrary method of accounting the cash method and the way the cash method recognizes debt; hence, the decision's rule is inherently itself arbitrary and sometimes unfair in close cases. Drawing the arbitrary line at another spot, as the dissent would do, merely moves the inevitable arbitrariness and potential unfairness to that other spot: it would not eliminate them. An additional importance of the Battelstein decision - unrelated to the cash method of accounting - lay in the court s description of the role of equity in tax law: We note further that even were this Court of the opinion that there are, as has been suggested, equitable considerations in this case favoring the Battelsteins, it has long been established that we may not allow such considerations to play a part in our decision. As panels of this Court have recently had occasion to reiterate, citing recent and established Supreme Court precedent, tax deductions are matters of legislative grace and must be narrowly construed. The taxpayer bears the burden of proving his entitlement to a particular deduction. Equity cannot supply a deduction when the Code does not grant one. C. Wilkerson v. Commissioner 12 In the 1981 Wilkerson v. Commissioner decision, the Court of Appeals for the Ninth Circuit similarly found a taxpayer had paid no interest for tax purposes. In Wilkerson, the lender placed loan proceeds within the taxpayer's control. The taxpayer then comingled the loan proceeds with a mere two dollars of non-loan proceeds. Immediately upon receipt of the loan proceeds and the resulting comingling, the taxpayer "paid" interest to the lender from the comingled account. The Court used the Burgess test to disallow the deductions. According to the Court, although the taxpayer had control over the loan proceeds, the taxpayer failed to show it had other assets from which it could have made the interest payment; therefore, no payment of interest occurred. D. Additional Issues: A full understanding of the BURGESS/BATTELSTEIN SCENARIO requires placement of the cases into common situations outside their immediate facts. Both cases involved the payment - or non-payment - of interest. As suggested earlier, with a small exception, all charitable contributions require "payment" to be deductible under section 170. Similarly, accrual method taxpayers with tort 12 655 F.2d 980 (9th Cir. 1981). 2008 by Steven J. Willis. All Rights Reserved. 6

and workers' compensation obligations must "pay" them to generate deductions because of section 461(h)(2)(C). One must also compare the "Payment versus Promise to Pay" distinction with the "Payment versus Deposit" distinction. The two scenarios have significant overlap. For both cash and accrual method taxpayers, a deposit itself will not generate a deduction if "payment" is necessary. Similarly, the receipt of a "deposit" by either cash or accrual method taxpayers does not generate income; instead, the receipt of an amount "paid" generates income under both accounting methods. 13 A fuller discussion of the "Payment versus Deposit" distinction appears in relation to the Indianapolis Power 14 decision. 13 For a discussion of how receipt of a "payment" generates income under the accrual method of accounting, see the SCHLUDE DOCTRINE. 14 Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990). 2008 by Steven J. Willis. All Rights Reserved. 7