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Cummings v. Commissioner of Internal Revenue

decided: October 31, 1974.


Appeal by Commissioner of Internal Revenue from judgment of the Tax Court, 61 T.C. 1 (1973), that a payment in satisfaction of an apparent liability under § 16(b) of the Securities Exchange Act was properly deductible as an ordinary and necessary business expense. Reversed.

Kaufman, Chief Judge, Smith and Timbers, Circuit Judges. Smith, Circuit Judge (concurring in the result).

Author: Kaufman

KAUFMAN, Chief Judge:

The interplay of two distinct statutory schemes often gives rise to some engrossing legal questions. In this case, we are called upon to consider the relationship of the Internal Revenue Code and the securities laws - in particular, the proper tax treatment of a payment made in satisfaction of an apparent liability under § 16(b) of the Securities Exchange Act.*fn1 We find that the policies of both statutes support the determination of the Commissioner of Internal Revenue that § 16(b) repayments should be treated as long term capital losses, and reverse the decision of the Tax Court allowing a deduction as an ordinary and necessary business expense.


Unlike those in many tax cases, the facts here are relatively straightforward. Nathan Cummings, chairman of the board and chief executive officer of Consolidated Food Corporation, was offered a large bloc of stock in Metro-Goldwyn-Mayer, Inc. [MGM] during 1959. He was told that the company was experiencing management problems, and that if he would become a director, three members of the board who were involved in controversy would resign. Cummings then purchased 51,500 shares of MGM stock for something more than $1,030,000, and was elected to the board after the three directors resigned.

The price of MGM stock rose, and on April 17, 1961, Cummings sold 3400 shares for a total of $227,648.28. His profit was properly reported as a long term capital gain on the 1961 tax return which he and his wife jointly filed. Between September 18 and October 2, 1961, however, Cummings bought back 3000 shares for $146,960.89. This purchase, within six months after the sale, brought him within the likely purview of § 16(b) of the Securities Exchange Act, making the difference between the sale price and the purchase price, $53,870.81, recoverable by MGM. Cummings was apparently unaware of his liability until soon after MGM, in preparation for its 1962 annual meeting, submitted its proxy material to the Securities and Exchange Commission. On January 16, 1962, the Division of Corporate Finance of the SEC informed Joseph A. Macchia, secretary of MGM, that if Cummings had realized profits from his sale and purchase, that fact would have to be noted in the proxy statement.*fn2 Macchia promptly communicated this to Cummings and although Cummings believed that any violation, if it did occur, was inadvertent, he nevertheless decided to remit the $53,870.81 to MGM. Cummings testified that the purpose of the payment was to prevent any delay in the issuance of MGM's proxy statement and also to protect his business reputation, which might be injured by a disclosure of his potential liability because of an alleged securities laws violation. The Tax Court gave credence to Cummings's version. In any event, MGM issued its proxy statement dated January 18, 1962, without reference to any potential liability outstanding from Cummings.*fn3

Cummings and his wife treated his repayment as a deduction against ordinary income on their 1962 income tax return, but the Commissioner disallowed this and assessed a deficiency of $45,790.18, maintaining that long term capital loss treatment was appropriate.*fn4 The Tax Court, 60 T.C. 91 (1973) held that the payment was properly characterized as an ordinary and necessary business expense, incurred to protect Cummings's business reputation. After the Court of Appeals for the 7th Circuit reversed a similar Tax Court decision, James E. Anderson, 480 F.2d 1304 (7th Cir. 1973), rev'g 56 T.C. 1370 (1971), the Tax Court reconsidered the case. It affirmed its previous holding, although six judges dissented and one abstained.*fn5


We are not required in this case to write on a tabula rasa, for the Courts of Appeals of two circuits have already rejected the Tax Court's treatment of § 16(b) repayments as ordinary and necessary business expenses. Anderson v. C.I.R., 480 F.2d 1304 (7th Cir. 1973), rev'g 56 T.C. 1370 (1971); Mitchell v. C.I.R., 428 F.2d 259 (6th Cir. 1970), cert. denied, 401 U.S. 909, 27 L. Ed. 2d 807, 91 S. Ct. 868 (1971), rev'g, 52 T.C. 170 (1969).*fn6 Our starting point, as was theirs, is Arrowsmith v. C.I.R., 344 U.S. 6, 97 L. Ed. 6, 73 S. Ct. 71 (1952), which held that an expenditure made for a business purpose will not be treated as an ordinary and necessary business expense if it is sufficiently related to an earlier capital gains transaction. Since the Commissioner relies heavily on Arrowsmith, brief recitation of the facts of that case would aid in the resolution of the legal issue here presented. Two individuals liquidated a corporation which they owned, and paid taxes on their profits at the long term capital gains rate. After the lapse of four years, a judgment was entered against the liquidated corporation which the individuals, as transferees of the corporate assets, were then required to pay. The Supreme Court disallowed deduction of the payment as a business expense, because, the Court reasoned, had the liability been satisfied in the year the corporation was liquidated, the payment would have been applied to reduce the taxpayers' long term capital gain. The payment was thus to be treated as a long term capital loss when it was made four years later.

The Arrowsmith rule was explained and applied in United States v. Skelly Oil Co., 394 U.S. 678, 22 L. Ed. 2d 642, 89 S. Ct. 1379 (1969). There, a corporation repaid money which it had recorded in an earlier taxable year as income reduced by the 27 1/2% oil depletion allowance. The Court held that the corporation could not deduct 100% of the repayment as a business expense since only 72 1/2% of the income had been subject to taxation. Arrowsmith was held to forbid the windfall which would result if income taxed at a special lower rate when received were deductible on repayment at a different and more favorable rate.

The nexus between the § 16(b) repayment and the earlier capital gains is apparent. The repayment "had its genesis" in the earlier sale, see Mitchell, 428 F.2d at 261, which was a prerequisite for § 16(b) liability. As the Anderson court noted, 480 F.2d at 1307, "The amount of liability is calculated by subtracting from the sales proceeds the lowest purchase price within the six-month period" so the repayment may properly be viewed as a return of a portion of the sales proceeds or as an adjustment of the sales price. In addition, the capital gain appears to include the profits from the sale and purchase. Cummings experienced a gain in the economic sense when he repurchased the stock at a lower price than that at which it was sold. But the only gain which he recognized for tax purposes was the capital gain on his original sale. Thus, for tax purposes, his payment of $53,870.81 profit from the sale and purchase may appropriately be regarded as an adjustment to the amount of that capital gain.

It is apparent, also, that Cummings would obtain a windfall like that condemned in Skelly Oil if we were to treat his § 16(b) repayment as an ordinary and necessary business expense. Both before and after the events at issue he owned the 3000 shares of MGM. In the interim, however, he consummated a sale which resulted in the recognition of a gain and a subsequent repurchase within six months - the combination of which violated § 16(b). The § 16(b) repayment was designed, so far as practicable, to restore the status quo prior to the offending sale and purchase. We would be remiss, therefore, if we allowed Cummings a windfall which would flow from permitting his gain to be taxed at a lower capital gains rate and his repayment - designed to erase the improper § 16(b) gains - to be deducted at the more favorable ordinary income rate.*fn7

The result we reach is supported not only by a proper interpretation of the tax laws, but by the policy of § 16(b) as well. Our longstanding interpretation of that provision, noted over 30 years ago, is that ". . . the statute was intended to be thoroughgoing, to squeeze all possible profits out of stock transactions" within its purview, Smolowe v. Delendo Corp., 136 F.2d 231, 239 (2d Cir.), cert. denied, 320 U.S. 751, 88 L. Ed. 446, 64 S. Ct. 56 (1943) in order to remove the incentive for short-term trading by corporate insiders. It would defeat this policy if insiders could reap a tax advantage by enjoying the low capital gains rate on realized gains while obtaining a deduction against ordinary income when they surrendered those gains in satisfaction of a § 16(b) liability. In this case, for example, Cummings would benefit by $45,790.18 if he were permitted to deduct his repayment as a business expense,*fn8 although (assuming that he elected the 25% alternate capital gains tax) he paid taxes of only $13,467.70 when he reported the comparable gain in 1961. Thus, he seeks to profit by $32,322.48 as a result of his § 16(b) transaction. We agree with the Seventh Circuit that, "Without good reason, we ...

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