UNITED STATES COURT OF APPEALS
For the Fifth Circuit
No. 95-60036
HUGHES & LUCE, L.L.P.,
ALAN J. BOGDANOW, TAX MATTERS PARTNER,
Petitioner-Appellant,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent-Appellee.
Appeal from the United States Tax Court
November 15, 1995
Before REAVLEY, JOLLY, and WIENER, Circuit Judges.
WIENER, Circuit Judge.
This federal income tax case finds a law firm appealing from
an adverse judgment rendered by the United States Tax Court. The
underlying dispute arose when, during the course of an audit, the
Internal Revenue Service (IRS) determined that "Service Costs"
deducted by Hughes & Luce, L.L.P. should be treated as
nondeductible loans to clients. The instant controversy concerns
the collateral issue of the proper tax treatment of currently-
received reimbursements of "Service Costs" previously deducted by
the law firm as expenses in earlier tax years. The Tax Court
upheld the IRS's adjustment to Hughes & Luce's then-current taxable
income, holding that the duty of consistency requires Hughes & Luce
to recognize income for these reimbursements. The Tax Court
declined to apply the tax benefit rule, however, relying on the so-
called "erroneous deduction exception." Agreeing with every other
circuit court that has addressed the erroneous deduction exception,
we conclude that it should be rejected, and that the judgment of
the Tax Court should be affirmed but on the basis of the tax
benefit rule.
I
FACTS AND PROCEEDINGS
Hughes & Luce, L.L.P. is a Texas general partnership engaged
in the practice of law. It commenced doing business on November 1,
1976. Hughes & Luce uses the cash receipts and disbursements
method of accounting for income tax purposes and files its tax
returns on a calendar year basis.
Although the terms of an engagement differ from client to
client, Hughes & Luce customarily bills clients separately for out-
of-pocket costs paid to third parties for expenses incurred in
connection with the firm's representation of those clients. These
costs include expenses for court costs, filing fees, expert witness
fees, travel and meals, long-distance telephone charges, delivery
services, and the like ("Service Costs").
On its income tax returns for the years 1976 through 1989,
Hughes & Luce deducted Service Costs as ordinary and necessary
business expenses in the year in which the expense was paid.
Reimbursements of these costs were included in its ordinary income
2
in the year received. Often the reimbursements were received in a
taxable year subsequent to the year in which the Service Costs had
been deducted as business expenses.
On March 30, 1992, the IRS began an audit of Hughes & Luce's
timely filed 1989 tax return. During the course of this audit, the
IRS challenged Hughes & Luce's treatment of the Service Costs. The
IRS contended that the firm's payments for Service Costs should be
treated as loans to clients. Accordingly, the Service Costs should
be neither deductible when paid nor includible in income when
reimbursed. For purposes of this case, Hughes & Luce concedes that
the Service Costs are properly treated as loans to clients for
taxable year 1989 and following.
For the taxable year 1989, Hughes & Luce had deducted Service
Costs in the amount of $2,367,535.1 Reimbursements totaling
$2,398,825 were included in income for this same year. Of the
total reimbursements, $1,908,509 was attributable to Service Costs
paid and deducted in 1989. The remainder of $490,766 was
attributable to Service Costs paid and deducted in years prior to
1989.2 It is these latter reimbursements that are at issue in this
case. As the statute of limitations had expired for the years
prior to 1989, the IRS was precluded from making an adjustment to
1
The majority of these Service Costs were described on
Hughes & Luce's income tax return as "Other Rebillable Expenses,"
and the remainder was interspersed among eighteen other categories
of expenses.
2
The parties have stipulated to the amounts above. As
acknowledged by the Tax Court, the $450 discrepancy between the
total reimbursements and the components thereof is immaterial for
purposes of our decision.
3
those years to disallow the deduction of these Service Costs.
Hughes & Luce essentially contends that none of the
reimbursements received in 1989 are taxable income because the IRS
determined them to be loan repayments, and loan repayments are not
ordinarily includible in income. The IRS counters that the
reimbursements received in 1989 but attributable to costs advanced
and deducted as expenses in years prior to 1989 are includible in
taxable income for 1989 under either (1) the tax benefit rule or
(2) the duty of consistency, which is also known as the doctrine of
quasi-estoppel. On June 1, 1993, the IRS sent Hughes & Luce a
Notice of Final Partnership Administrative Adjustment for its 1989
tax year, reflecting an adjustment to its taxable income of
$422,457.3
Hughes & Luce filed a petition in the Tax Court challenging
the IRS's determination. The Tax Court held that, as the
deductions for Service Costs in years prior to 1989 were improper,
the tax benefit rule was inapplicable under the so-called
"erroneous deduction exception." The court went on to hold,
3
The adjustment was calculated as follows:
Service Costs deducted but not
reimbursed as of December 31, 1988 $490,766
Service Costs deducted
in 1989 $2,367,535
Service Costs reimbursed
in 1989 (2,398,825) ( 31,290)
Less: Bad debt deduction ( 37,019)
Adjustment to Hughes & Luce's
taxable income for 1989 $422,457
4
however, that Hughes & Luce was required to include the amount in
issue in its income under the duty of consistency. Hughes & Luce
now appeals that decision.
II
ANALYSIS
A. STANDARD OF REVIEW
In reviewing decisions of the Tax Court we apply the same
standards used in reviewing a decision of the district court:
Questions of law are reviewed de novo; findings of fact are
reviewed for clear error.4
B. TAX BENEFIT RULE
The federal income tax is based on an annual accounting
system, which is "a practical necessity if [it] is to produce
revenue ascertainable and payable at regular intervals."5 Strict
adherence to an annual accounting period, however, may create
transactional inequities.6 The tax benefit rule was adopted in an
equitable effort to mitigate some of the inflexibilities of the
annual accounting system by approximating the results that would be
produced in a system based on transactional rather than annual
accounting.7
4
Estate of Hudgins v. Commissioner, 57 F.3d 1393, 1396 (5th
Cir. 1995).
5
Hillsboro Nat'l Bank v. Commissioner, 460 U.S. 370, 377
(1983) (citing Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365
(1931)).
6
Id.
7
Id. at 377, 381.
5
The tax benefit rule includes an amount in income in the
current year to the extent that: (1) the amount was deducted in a
year prior to the current year, (2) the deduction resulted in a tax
benefit, (3) an event occurs in the current year that is
fundamentally inconsistent with the premises on which the deduction
was originally based, and (4) a nonrecognition provision of the
Internal Revenue Code does not prevent the inclusion of gross
income.8 An event is fundamentally inconsistent with the premises
on which the deduction was originally based if that event would
have foreclosed the deduction had it occurred in the year of the
deduction.9
The Tax Court held that application of the tax benefit rule
was improper in this case because of the "erroneous deduction
exception." That exception provides that the tax benefit rule
applies only when the original deduction was proper.10 Because the
disbursement of a loan (i.e., Service Cost) is not a proper
deduction, the Tax Court concluded that the tax benefit rule did
not require Hughes & Luce to include the amount in issue in its
1989 taxable income.
In its opinion, the Tax Court noted candidly that the
erroneous deduction exception has been criticized or rejected by
8
Id. at 383-84; Frederick v. Commissioner, 101 T.C. 35, 41
(1993).
9
Hillsboro, 460 U.S. at 383-84.
10
See Canelo v. Commissioner, 53 T.C. 217, 226 (1969), aff'd
on other grounds, 447 F.2d 484 (9th Cir. 1971).
6
many Courts of Appeals.11 The Tax Court nevertheless applied this
exception in the instant case because we had not squarely addressed
this issue. We do so now and join the other circuits in rejecting
the erroneous deduction exception.
The rationale underlying the erroneous deduction exception
was explained by the Tax Court in Canelo as follows:
We realize that [the taxpayers] herein have received a
windfall through the improper deductions. But the
statute of limitations requires eventual repose. The
"tax benefit" rule disturbs that repose only if [the IRS]
had no cause to question the initial deduction, that is,
if the deduction was proper at the time it was taken.
Here the deduction was improper, and [the IRS] should
have challenged it before the years prior to 1960 were
closed by the statute of limitations.12
Like the other Courts of Appeals before us, we are not persuaded by
this reasoning or by the arguments advanced by Hughes & Luce in
support of this exception.
As other courts have observed, the inclusion of the
reimbursements in income does not reopen the tax liability for the
prior yearsSQalbeit the result is much the sameSQand does not
11
See Unvert v. Commissioner, 656 F.2d 483, 485-86 (9th Cir.
1981), cert. denied, 456 U.S. 961 (1982); Union Trust Co. v.
Commissioner, 111 F.2d 60, 61 (7th Cir.), cert. denied, 311 U.S.
658 (1940); Kahn v. Commissioner, 108 F.2d 748, 749 (2d Cir. 1940);
Commissioner v. Liberty Bank & Trust Co., 59 F.2d 320, 325 (6th
Cir. 1932).
12
Canelo v. Commissioner, 53 T.C. 217, 226-27 (1969), aff'd
on other grounds, 447 F.2d 484 (9th Cir. 1971).
7
implicate the statute of limitations.13 The only taxable year
affected by application of the tax benefit rule is the year in
which the reimbursements are received, which year must be open for
the rule to apply at all. That these reimbursements are properly
treated as loan repayments does not prevent their taxation when, as
here, the loan disbursements were erroneously deducted in a prior
year as an expense. The tax benefit rule requires taxation because
of a previously created tax benefit, regardless of an item's
inherent characteristics (i.e., whether repayment of a loan or
recovery of a deductible expense) and regardless of whether the
original deduction was proper or improper.14 We also agree with the
court in Unvert that the erroneous deduction exception is poor
public policy in that it rewards the taking of improper tax
deductions. We therefore reject the erroneous deduction exception
and conclude that the tax benefit rule applies regardless of the
propriety of the original deduction.
Hughes & Luce argues that the Supreme Court's decision in
Hillsboro National Bank v. Commissioner effectively overruled prior
cases that rejected or criticized the erroneous deduction
exception. Selectively pointing to language and examples in that
case, Hughes & Luce asserts that Hillsboro leaves no doubt that the
tax benefit rule can be applied only when the original deduction
was proper. We disagree, finding this to be a strained
13
Dobson v. Commissioner, 320 U.S. 489, 493 (1943); Unvert
v. Commissioner, 656 F.2d 483, 485-86 (9th Cir. 1981), cert.
denied, 456 U.S. 961 (1982).
14
Unvert, 656 F.2d at 486.
8
interpretation of Hillsboro.
At issue in Hillsboro was whether the tax benefit rule was
limited to situations in which a taxpayer recovers an amount
previously deducted or, alternatively, whether it also applies when
an event in a later year is fundamentally inconsistent with the
premise on which the deduction was claimed.15 Neither the propriety
of the original deductions nor the validity of the erroneous
deduction exception was ever in question in Hillsboro. Thus, we
are unpersuaded by this argument.
Hughes & Luce also contends that there is no fundamentally
inconsistent event in this case because the very nature of
"rebillable expenses" is that reimbursement of such expenses is
expected. Thus, Hughes & Luce insists, it is improper to invoke
the tax benefit rule. This argument misses the mark. In holding
that a fundamentally inconsistent event is a requirement to invoke
the tax benefit rule, the Supreme Court in Hillsboro expanded that
rule by refusing to limit it to situations involving an actual
recovery. The actual recoveries by Hughes & Luce of the Service
Costs at issue plainly are fundamentally inconsistent events in
that they would have foreclosed the deduction had they occurred in
the same year as the disbursements.16
C. DUTY OF CONSISTENCY
As we affirm the Tax Court on the basis that the tax benefit
rule requires Hughes & Luce to include the amount at issue in its
15
Hillsboro, 460 U.S. at 381.
16
See Hillsboro, 460 U.S. at 383-84.
9
1989 taxable income, we need not and therefore do not consider the
Tax Court's holding that this same result is required under the
duty of consistency. This should not be construed as either
agreeing with or rejecting the Tax Court's treatment of that
matter.
III
CONCLUSION
For the foregoing reasons, we reject the erroneous deduction
exception and conclude that the tax benefit rule applies regardless
of the propriety of the original deduction. We therefore affirm
the Tax Court's judgment, albeit we do so on the basis of the tax
benefit rule rather than on the reason expressed by the Tax Court.
AFFIRMED.
10