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Realization and its evil twin deemed realization.

This article analyzes the various deemed realization events contained in the Internal Revenue Code of 1986 (Code), as amended. The article discusses the constitutional origins of the realization doctrine and the congressional drift away from these underpinnings towards an accretion system of taxation. The article analyzes whether there is a consistent tax policy objective behind the numerous mark-to-market deviations and deemed sales and distributions carved out by Congress in certain Code sections. The authors suggest deemed realization by statute has become a necessary evil for the proper administration of the realization doctrine. Without such, taxpayers postured in a particular manner would be permitted to forever escape income taxation on appreciated assets due to certain inherent shortcomings in the existing statutory and judicial structure of the doctrine.

I. INTRODUCTION                                                 574


A. The classic Economic Definition of Income v. Income or Tax   576

B. Realization as a constitutional Condition Defining Income    579

C. The End Days of the Macomber "Severance" Requirement         584

D. Realization a Matter of "Administrative Convenience" per     587
Court Dictum

E. The Academic Embrace of Supreme Court Dictum                 590

F. Hold Your Ponies, Realization is Breathing                   596

G. A New Definition of Income with Its Old Friend Realization   597

H. Gains Must Still be "Derived From" and "Clearly Realized"    598

I. Laying the Bricks and Mortar, for Realization                600

J. Another Foregone Opportunity to Overrule Macomber            603

III. ELECTIVE REALIZATION                                       608

A. A Mark-to-Market Election for Some. But not All              608

B. Election for Traders in Securities, Commodities Dealers and  609
Commodities Traders

C. Investors, Dealers, and Traders Distinguished                610

D. No Constitutional Objections from Traders in Securities and  612

E. The Election for Securities in Passive Foreign Investment    613


A. Penalizing certain Accumulations of Corporate Earnings       616

B. Tax Avoidance with Personal Holding Companies                619

C. Let's Take the Personal Holding Company Overseas             621

D. The Subpart F Anti-Deferral Regime                           623

E. The Constitutionality of Penalizing Entities                 626

F. Deemed Realization on Expatriate Exits                       627

G. Section 1256 Contracts and Mark-to-Market Taxation           630

H. Section 817A Modified Guaranteed Contracts                   631

I. Dealers in Securities and Tax Avoidance                      633

V. CONCLUSION                                                   635


This article analyzes congressional deviations from the constitutional "realization" doctrine described in case law and implicit in section 1001. (1) The article discusses specific taxpayer situations where--because of the unique manner in which the taxpayer holds a particular asset (or assets)--a mark-to-market provision is triggered overriding the realization requirement. The realization requirement generally requires some sort of identifiable event prior to gain or loss recognition. Under certain limited circumstances in the Internal Revenue Code (Code), realization is "deemed" to have occurred even though no actual transfer, exchange, sale, or other disposition of the asset has transpired. A subset of these "deemed realization" events penalizes taxpayers for avoiding realization events (e.g., the accumulated earnings tax).

The authors will use the broadly-used term "deemed realization" to refer to this tax phenomenon of cherry-picked accretion taxation; namely, involuntary realization triggered not by an affirmative act of the taxpayer, but rather mere Congressional "posturing" (i.e., Congress disapproving of holding an asset or assets in a specific manner). In theory, one might argue that the original issue discount (OID) rules also trigger deemed realization on OID accrual, as this statutory accrual may differ markedly from the taxpayer's ordinary method of accounting. This article leaves the OID rules for another discussion, as they are at most an issue of timing, and a fictional disposition of an asset does not occur. (2) This article also does not address the deemed realization events implicit in depreciation deductions, as the mechanics involved with depreciation deductions do not replicate the disposition of an asset or assets. Rather, such expenses represent the deferral of the timing of a deduction from when the expense was actually incurred to when it is deemed used as a result of the passage of time. Instead of permitting an immediate expense deduction on a capital expenditure, the Code requires taxpayers to capitalize their cost and recover their economic outlay through depreciation deductions over the useful life of an asset, which, as with OID accruals, is merely a question of timing. (3)

The article focuses on accretion taxation impacting expatriates, securities and commodities dealers and traders, holders of certain appreciated financial instruments, corporations with accrued but undistributed earnings, personal holding companies, and U.S. shareholders of certain foreign corporations or investments. The authors conclude that the mark-to-market exceptions in the Code on certain taxpayers and the penalties imposed upon those taxpayers unreasonably delaying realization are a necessary and unavoidable evil in tax law. Deemed realization and certain penalties on accumulated earnings are necessary to prevent taxpayers from unreasonably avoiding realization on the pregnant gain in appreciated assets through various tax strategies, including escaping the U.S. tax umbrella altogether by exiting the U.S. tax system. The statutory exceptions described herein were enacted by Congress because it is at the outer contours of realization where neither the judicial doctrine of realization, nor its implicit counterpart in section 1001, are sufficient to deter tax avoidance at those contours.


A. The Classic Economic Definition of Income v. Income for Tax

The doctrine of realization has been intertwined with the federal tax definition of income since the early days of the U.S. income tax system.

Realization is pervasive in our tax laws, and has historically been the foundation upon which income inclusion is built. (4) Notwithstanding such, the exact parameters of realization (and a precise definition of income) remain a mystery to this day for scholars, judges, and practitioners. On the other hand, economists have generally avoided realization as a requirement when defining income. The most widely held economic definition of income in academic literature is the "Haig-Simons" definition. In the early part of the 20th century, economist Robert Murray Haig theorized that income should be defined as a "flow of satisfactions, of intangible psychological experiences." (5) Of course, even Mr. Haig agreed that such an analytically malleable definition was far too impractical for the proper administration of an income tax system. (6) Therefore, Mr. Haig suggested a tax definition of income as "the money value of the net accretion to one's economic power between two points in time." (7) This language was also intended to include the taxpayer's consumption as a factor and was thought to be interchangeable with the definition formulated a decade later by economist Henry C. Simons. (8) Simons defined income in what is now known as the Haig-Simons definition as "the algebraic sum of (1) the market value rights exercised in consumption and (2) the change in the value of the store property rights between the beginning and end of the period in question." (9) Stated another way, income is the sum of the value of the taxpayer's consumption during the period of assessment and the change--whether positive or negative--in the net value of his or her assets during such period.

For example, suppose a taxpayer purchased a capital asset in year one for $200x and at the end of year two the asset increases in value to $250x. Under the Haig-Simons definition of income, the taxpayer would have $50x of "economic income" because the asset appreciated in value from year one to year two by $50x. The taxpayer is therefore economically in a better position. This is the case even though the taxpayer still holds the asset, and may not have the cash available to pay the tax on the $50x of economic gain should it be deemed to be taxable gain. On the other hand, if the asset declines in value, and is only worth $175x in year two, the taxpayer has an economic loss of $25x. As stated by Professor Kornhauser, this approach has been referred to as the "quantum theory." (10) Another approach is the "res theory." Under that theory, income is not measured by the change in the value of capital (whether consumed or replaced) but only from the periodic product of capital. (11) That is, capital is like a fruit tree and only the fruit is income under this theory. (12) Whether the tree grows, shrinks or is exchanged for another asset, it remains capital under this theory. (13) Accordingly, fluctuations, conversions, and even consumption do not change the character of the asset as capital.

As stated previously, under the Haig-Simons construction, a mere change in the value of one's assets due to appreciation or depreciation between two points in time results in an accession to wealth or decrease in wealth, as the case may be, and thus, economic income in the case of the former. Thus, in the example above, the taxpayer has economic income or loss even though there is no sale or disposition of the asset. Nevertheless, even the theorists propounding the Haig-Simons definition understood its administrative impracticalities; it is simply not a workable standard for an income tax system. These administrative impracticalities are the historical and conceptual basis for the realization requirement as a precondition to gross income under section 61. (14) Thus, in the above example, the taxpayer would have no income or loss to report until he or she makes a sale, exchange, transfer, or other disposition of the asset.

In describing the significance of realization, Simons stated,
  The proper underlying conception of income cannot be directly and
  fully applied in the determination of year-to-year
  assessments. Outright abandonment of the realization criterion would
  be utter folly . ... Our income taxes, as a matter of declaration,
  of administration, and of adjudication, rest upon great masses of
  business records and accounts; they simply must follow, in the main,
  the established procedures of accounting practice. Thus, they must
  follow realization criterion, but not so blindly and reverently as
  in the past. (15)

In other words, valuation difficulties, liquidity issues and administrative difficulties are among the foremost reasons the definition of income for tax purposes has deviated from that utilized by economists. (16) Notwithstanding these grounds, the relationship between the definition of income for tax purposes and realization has been rocky since the early days of our income tax system. (17) As discussed by Professor Kornhauser, the Supreme Court has struggled over the years with the realization concept in its numerous attempts to define "income" as the term is used in the Sixteenth Amendment of the United States Constitution. (18)

Not discussed in the Macomber case below (nor further in this paper) is the concept of economic income derived from using one's own labor in lieu of paying another. If one paints his own house or repairs his own vehicle, he has saved the amount he would have paid a professional. While one might argue that he is economically enriched, no one would argue that the enrichment constitutes a realization event leading to income recognition.

B. Realization as a Constitutional Condition Defining

Income In 1920, the Supreme Court made one of its first major attempts at defining income, while also properly addressing its relationship with realization, in Eisner v. Macomber. The Macomber decision came after a series of prior cases, which defined income but did not directly discuss realization. (19) The issue before the court was whether pro-rata common-on-common stock dividends constituted "income" to the shareholder taxpayer under the Sixteenth Amendment. (20) In a similar case, the Supreme Court had previously discussed stock dividends in the case of Towne v. Eisner and held that they did not constitute income. (21) Towne, however, involved stock dividends based on earnings that had accumulated in the corporation prior to the adoption of the Sixteenth Amendment. (22) Towne was also distinguishable because it involved the Income Tax Act of 1913 (which did not expressly include "stock dividends" as income). (23) Whereas Macomber involved the Revenue Act of 1916, which expressly provided that stock dividends were income under the Act. (24) In other words, the Macomber court was calling into question Congress's constitutional authority to characterize stock dividends as income. Nevertheless, regardless of these subtle distinctions, the Macomber court ruled along similar lines.

According to the majority in the Macomber court, the Sixteenth Amendment was not intended to extend to Congress the power to tax new subjects. (25) But rather, the purpose behind its enactment was to remove the apportionment requirement among the states with respect to income. (26) The court further stated that Congress (and the courts) could not override the amendment's genesis (which was to remove the apportionment requirement) with a "loose construction" of the provision. (27) In other words, the definition of income and its scope is a constitutional question, and not a matter that can be concluded by legislative action. (28) By characterizing income as a constitutional question (which the Constitution does not define), the Lochner era court reserved judicial discretion to define income in future cases. (29) This set the stage for years of protracted taxpayer controversies over the proper definition of income and the concept of realization. In Macomber, the majority stated that Congress could not turn what would normally be "capital" into "income" within the purview of the amendment by merely classifying it as such. (30) The Sixteenth Amendment was designed to tax the fruit of the tree, not the tree itself. (31) A direct tax on capital, i.e. the tree, would require apportionment among the several states. (32)

Capital has historically received preferred tax treatment in taxation dating all the way back to early British income taxation. (33) The idea was that capital was to be reinvested and reserved for the oldest male heir. (34) As a result, capital assets have historically received preferential treatment. For a while, capital gains were entirely excluded from income under early British income tax laws and have almost always been given preferential treatment in the U.S. (35) At the time of Macomber, some academics used res theory to argue that capital gains were never taxable as income, notwithstanding that Macomber's express conclusion to the contrary. (36) Macomber, in effect, defined income under the res theory (only the fruit is taxable), but adopted part of the quantum theory, i.e. while accretion of value in a capital asset was not itself included in income, the increased value in the capital evidenced by a sale or other separation of that asset was income.

In reviewing its prior decisions (interpreting income under the Corporation Tax Act of 1909), the Supreme Court stated it had little to add to its former definition interpreting income as "gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets." (37) The court stated that the government's argument was flawed, insofar as it contended that stock dividends constituted "gain" to the taxpayer. (38) The argument overlooked realization, in that gain is "derived from" capital, as income does not include gain "accruing to" capital, or an "increment of value" in the investment. (39) The interconnected relationship between realization and income (according to the court) is expressed in the Sixteenth Amendment. (40) The court stated, among other things, "The same fundamental conception is clearly set forth in the Sixteenth Amendment--'incomes, from whatever source derived'--the essential thought being expressed with a conciseness and lucidity entirely in harmony with the form and style of the Constitution." (41)

Detailing the contours of realization, the majority stated that gain is derived from something of "exchangeable value," proceeding from the property, "severed from" the capital, and coming in to the taxpayer, being "derived" or "received" for his or her separate use, benefit, and disposal. (42) As for the issuance of common stock on common, the court determined a realization event simply does not occur, as constitutional income simply does not exist without realization. (43) In the end, the taxpayer "derived" nothing from the transaction, except mere paper certificates representing undistributed earnings. (44) In other words, the taxpayer received nothing out of the company's assets for the taxpayer's separate use and benefit. Accordingly, for realization to occur the profit must somehow be "segregated" from capital, and in the case of a pro-rata stock dividend, no such segregation occurs. (45) Economic income consisting of mere enrichment through an increase in value of capital is not income under the Sixteenth Amendment. (46) The court found the stock dividend had changed "only the form, not the essence" of the taxpayer's capital investment. (47) A mere change in form, however, without any severance of the underlying investment was not sufficient.

The Macomber decision was a closely divided opinion of 5-4, and has been extensively criticized by scholars as creating the constitutional requirement of realization, but not developing that concept. (48) The idea of realization, although not initially clear, has developed significantly over the years; now, tax law is clear that a sale, exchange, or "other disposition" all constitute realization events. In Macomber, there were two separate dissenting opinions, one by Justice Holmes with Justice Day concurring, and another by Justice Brandeis with Justice Clark concurring. Justice Holmes was the same justice that wrote the majority opinion in Towne, (49) which also held stock dividends were not income. Towne, although comprised of identical justices, was not a divided opinion like Macomber, and, as previously stated, was based on a different statute.

Justice Holmes's dissent was brief and to the point, stating that the decision of Towne was correct as it construed the then-existing Income Act. (50) Whereas, the question before the court in Macomber was whether the Sixteenth Amendment was broad enough in scope to include stock dividends within the proper construction of "income," (51) Justice Holmes argued for a more liberal interpretation of income, stating, "the Sixteenth Amendment should be read in a sense most obvious to the common understanding at the time of its adoption." (52) Justice Holmes further stated the purpose of the Amendment was to eliminate these "nice questions as to what might be direct taxes." (53) In other words, Holmes disagreed with the majority's narrow interpretation of the Sixteenth Amendment, which premised its passage as a mere elimination of the income apportionment requirement among the several states.

Justice Brandeis, in a much lengthier dissent, also argued for a broader interpretation of the Sixteenth Amendment, which would include stock dividends. (54) According to Brandeis, stock dividends were a method corporations used at the time to distribute accumulated profits among shareholders without actually distributing the profits. (55) Brandeis construed this as a form of tax avoidance by taxpayers and their advisers. (56) Taxpayers would use various stock dividend transactions to bail such earnings out of the corporate entity without taxation. (57) Nevertheless, Brandeis further stated that whether or not a corporation decides to distribute a capital asset or a distribution of profits is wholly a matter of "financial management" of the entity, as both are still dividends. (58) He also rejected the idea of realization as a precondition to constitutional income. (59) Brandeis disagreed with the argument asserted by the majority that until there is a severance of the profits from the entity, the shareholder does not really know whether or not he has received any gains. (60) As Brandeis stated, cash dividends are often declared by a corporation, and later instead paid out of capital because of unforeseen forecast errors. (61) As a result, Brandeis stated that, until the entity is completely liquidated, it is virtually impossible to determine whether there have been any corporate profits, unless the returns exceed that amount originally invested by the stockholders. (62)

Congress codified the Macomber decision in the Revenue Act of 1921, providing, "A stock dividend shall not be subject to tax." (63) Both the committee reports for the House and the Senate involving the bill stated that the Act modified the definition of dividends in existing law by exempting stock dividends from income taxation, as required by Macomber. (64) Although Macomber only dealt with pro-rata stock dividends, the then-existing Treasury and Congress interpreted Macomber more broadly than necessary, exempting all dividends from taxation. The current Code provision section 305(a) exempts certain stock dividends from income and is now more consistent with Macomber in that pro-rata stock dividends and rights continue to be exempt from taxation, while subsection (b) sets forth a list of various other stock dividend transactions which are not exempt (e.g., shareholders may receive cash or stock, the distributions are disproportionate with some shareholders receiving stock and others receiving property, etc.). (65)

C. The End Days of the Macomber "Severance" Requirement

In 1940, the Supreme Court in Helvering v. Bruun addressed realization again, extending its parameters a bit further from those delineated in Macomber. The Bruun court stated for realization to occur there does not necessarily always have to be a strict "severance" of the taxpayer's gain from the capital investment. (66) Bruun involved a landlord that leased out his property on a long-term lease. (67) The landlord and the tenant had both agreed the tenant could remove an existing building from the property and construct his own, so long as the improvement remained on the property, after the termination or expiration of the ninety-nine year lease. (68) Theoretically, at the end of the lease term, the building (with a useful life of not more than fifty years) would have little or no value remaining because of the lease term and thus there would be no taxable (or economic) income to the taxpayer at its expiration.

Three and one-half years into the lease term, however, the tenant defaulted on the payment of rent (and taxes) and the landlord regained possession of the improved premises. (69) As a consequence, the Service asserted the landlord had taxable income in an amount equal to the net fair market value of the tenant's improvement (i.e., the fair market value of the building minus the unamortized costs of the removed building). (70) The landlord, on the other hand, contended a realization event had not occurred under Macomber because the improvement remained fixed to the capital asset (i.e., the land) un-severed. (71) In other words, when the landlord regained possession of the real estate the essential element of realization (i.e., severance) had not transpired. (72)

Backtracking slightly from Macomber, the court determined a realization event had in fact occurred in the year of repossession. (73) The court stated its previous discussion of property being "severed" from capital was only an attempt to distinguish stock dividends from income classification where the shareholder's economic position remained unchanged. (74) In other words, the court was limiting the severance requirement to stock dividend transactions. Furthermore, the court stated realization does not always require the actual receipt of cash from the sale of an asset. (75) Rather, gain may occur as a result of an exchange of property, the assumption of a taxpayer's debt, or any other form of profit realized on the completion of a transaction. (76) By holding that realization could occur with an un-severed asset, the court moved away from its prior stab at defining realization, and drew its circumferential boundaries a bit broader. Nevertheless, by no means did the court expressly abandon realization as a constitutional criterion. Constitutional income must still be derived from something.

In many respects, the Bruun court simply broadened the definition of "derived" by not limiting it exclusively to capital being severed. The Court stated profit was realized in the transaction when the benefit of an increased value in the property was conferred upon the taxpayer. (77) Although the form of the transaction may not have appeared altered on its face, its "economic substance" clearly was. In many respects the court's determination that the taxpayer recognized gain without any severance seemingly resembles economic income under the Haig-Simons definition. Nevertheless the Court distinguished the transaction at issue from economic income by stating realization was satisfied because there was the "completion of a transaction." (78) As previously mentioned, economic income is not premised on transactions, but rather periodical assessments, based on changes in taxpayer wealth. The court stated, in relevant part,
  While it is true that economic gain is not always taxable as income,
  it is settled that the realization of gain need not be in cash derived
  from the sale of an asset. Gain may occur as a result of exchange of
  property, payment of the taxpayer's indebtedness, relief from a
  liability or other profit realized from the completion of a
  transaction. The fact that the gain is a portion of the value of
  property received by the taxpayer in the transaction does not
  negative its realization. (79)

The end result of gross income inclusion to the landlord in Bruun would now differ under sections 109 (80) and 1019. (81) Section 109 provides that improvements made by the tenant do not constitute gross income to the landlord on termination of the lease (other than improvements that function as rent). (82) Section 1019 correspondingly states the landlord is not to adjust the property's basis for any tenant improvements not included in income. (83) These two provisions eliminate the inequitable result of Bruun; namely, that there has not been a severance of the capital to provide liquidity to pay the taxes. Furthermore, construing tenant improvements as gross income to the landlord is also inequitable from a tax-policy standpoint if the tenant improvements were conducted without consent. In Bruun the parties also never intended the improvements to inure to the benefit of the landlord as the property was under a long-term lease. The enactment of sections 109 and 1019 further evidences a congressional preference towards not taxing a Bruun type transaction that more closely resembles mere economic income. In other words, perhaps the Bruun court got it wrong. Perhaps they interpreted realization too broadly.

D. Realization a Matter of "Administrative Convenience" per Court Dictum

The next Supreme Court case expanding on realization was Helvering v. Horst. (84) Horst involved a cash basis taxpayer owning bonds that removed the bond's negotiable interest coupons (before their due dates) and gifted them to his son. (85) After receipt of the interest coupons, the son collected interest on the bonds in the same year. (86) The issue before the court was whether the father's transfer of the coupons constituted a realization event, thus triggering income recognition to the donor (equal to the interest payments). (87) The court stated,
  Admittedly not all economic gain of the taxpayer is taxable income.
  From the beginning the revenue laws have been interpreted as defining
  "realization" of income as the taxable event, rather than the
  acquisition of the right to receive it. And "realization" is not
  deemed to occur until the income is paid. But the decisions and
  regulations have consistently recognized that receipt in cash or
  property is not the only characteristic of realization of income to a
  taxpayer on the cash receipts basis. Where the taxpayer does not
  receive payment of income in money or property realization may occur
  when the last step is taken by which he obtains the fruition of the
  economic gain which has already accrued to him. (88)

As was the case of Bruun, the Court was not content with limiting itself to a tight construction of realization, confined to actual cash and property received or other clear severance scenarios. Although a cash method taxpayer generally does not realize income when the right to receive it accrues, but rather upon receipt of the actual payment, the Court stated there are exceptions. (89) Particularly, when a taxpayer has fully enjoyed the benefit of the economic gain attributable to the right to receive income, in such a situation, the taxpayer cannot escape taxation by simply not directly receiving the payment. (90)

In dictum, the Court then stated the requirement of realization is a matter of "administrative convenience," as it only postpones the inevitable tax to the final event of enjoyment. (91) A taxpayer cannot escape taxation by creating an event other than direct receipt (e.g., a gift)--yet consummate economic enjoyment of the asset. (92) What the Court was aiming at in its dictum was a taxpayer does not avoid realization by simply assigning his or her income to another, but rather triggers realization. The Court made no mention of Macomber or that its holding realization stems from the expressed language contained in the Sixteenth Amendment. Nevertheless, in a string of dicta, the Court stated realization was founded on administrative convenience. By implication, the Court suggested realization was not founded on the expressed language in the Constitution as suggested in Macomber. Horst, however, is--at heart--an assignment of income case, and not a realization case. Its opinion is premised on the assignment of income doctrine decided in Lucas v. Earl. (93) The Lucas case is the grandfather of the assignment of income cases and its underlying principles are still applicable today. (94) The holding, however, no longer applies to married taxpayers filing a joint tax return.

Horst determined the donor had "realized" income when he gifted the interest coupons to his son, because the disposition of the coupons procured a satisfaction to the taxpayer of money or money's worth.95 The taxpayer enjoyed an economic benefit when he disposed of the coupons (i.e., the transfer of a valuable gift), a benefit that could (but for the gift transfer) only be realized upon disposition of the coupons or collection of the interest. (96) As far as realization was concerned the transaction was the same as if the taxpayer had collected on the coupons and gifted the income. (97) Could not the same argument be made, however, with regard to gifts of appreciated property? Does not the donor under such circumstances enjoy the economic benefit of such built-in gains when he or she gifts the property, while avoiding the tax recognition event? Certainly, an "other disposition" has occurred, which Congress has intentionally chosen over the years to ignore in the case of gifts and inheritances. With gifts the gain is preserved in the carryover basis of the property received by the donee under section 1015. (98) Perhaps an argument can be made that section 1015 by implication provides a section 1001(c) exception to recognition. (99) Like most deferral provisions, however, the gain is preserved for future income recognition. Such is generally not an issue for inheritances on the other hand, because the basis of the property received by the beneficiary is stepped-up (or down) to the fair market value at the date of decedent's death (or its value at the alternative valuation date if applicable) under section 1014. (100) Another distinction might be made under the assignment of income doctrine. Meaning, the distinguishing factor triggering realization for the Horst court was the assignment of income doctrine. (l01) Hoist confirms that, although the gift tax system generally ignores realization, it cannot be a backdoor around assignment of income principals.

In 1963, President Kennedy proposed to Congress a tax at the capital gains rate on unrealized gain on certain assets transferred by gift or inheritance as a means of generating federal revenue. (102) Losses were also to be recognized under this proposa1. (103) The Secretary of the Treasury C. Douglas Dillon suggested in a memorandum opinion submitted to Congress that the proposed tax was constitutional. (104) The position advanced by the Secretary (and by academics) was that realization had been relegated to a matter of practicality, not constitutionality when the post-Macomber cases refined the concept. (105) In his opinion, it was highly probable the Supreme Court would recognize the power in Congress to tax unrealized appreciation if faced with the issue. (106)

The Secretary's memorandum stated that if a taxpayer makes a gift or bequest the taxpayer has exercised control over the unrealized accrued gains, and, therefore, realization occurs, the same as it does in the assignment of income cases, even though there has been no severance of the gain. (107) The Secretary argued that deemed realization was already occurring under the Personal Holding Company Act of 1937, (108) which was held constitutional by the Supreme Court in Eder v. Commissioner. (109) President Kennedy's proposed legislation was never enacted though, and gifts and inheritances continue to be transactions where realization is ignored. The Treasury attempted it again in 1969, by proposing similar rules that would tax unrealized gains, but these rules were also not adopted. (110) Interestingly, similar to an exchange, there is not a severance of the gain from the capital when property is transferred by gift. The purpose of a gift, however, is typically not one of tax-avoidance, and therefore deemed realization from a tax-policy perspective is not warranted (unless a Horst type situation exists): (111)

E. The Academic Embrace of Supreme Court Dictum

When Horst mentioned the rule of realization was primarily founded on administrative convenience, it was most likely in reference to the dilemma of using the economists' definition of income for tax purposes, not that it was not constitutionally required. Nevertheless, notwithstanding the practical barriers to taxing mere accretions in value, some scholars have suggested the requirement should be abandoned entirely, in favor of a mark-to-market income tax system in certain circumstances. (112) This suggested departure, however, has gained little congressional traction over the years, as it is not politically feasible to tax such paper gains and it poses taxpayer liquidity issues. (113) Even stronger than the unpopular political aspects of such an approach the administrative and practical aspects of implementing such a system could be Draconian. The difficulty in measuring asset fluctuation, presumably at the end of a taxable year without the availability of a public marketplace in the particular asset at issue, is obvious. Additionally, with even two appraisers involved, one might still have more than three opinions as to value. Furthermore, liquidity is at the core of any sound tax system. Imposing a tax when the taxpayer does not have the requisite cash to pay can lead to a myriad of issues. Although, as discussed herein, there are some circumstances in the Code where mark-to-market taxation has been implemented on a piecemeal basis and realization is deemed to have occurred. Although Horst did not involve taxpayer gain (but rather interest income), many scholars and commentators have contended over the years that the Court's dictum reference significantly relaxed (if not eliminated) the realization requirement. (114)

In this light, presumably the Supreme Court's retreat in Bruun and Horst (decided ten days later) from its strict interpretation of realization suggests the various deemed realization events in the Code are constitutional. Although this is unclear, as a review of relevant case law indicates, our courts have never entirely abandoned realization, and certainly Horst did not address Macomber head on. Yet, scholars have overwhelmingly asserted that this dictum reference loosened the reigns of constitutional realization. One of the first academic articles to suggest there was no longer any continuing vitality to the Macomber realization requirement was written by Professor Surrey in 1941. (115) Bruun was Surrey's interpretive "turning point in realization jurisprudence from a constitutional concept to an administrative convenience rule under which [legislators] and administrators determine when it is appropriate to end the postponement of taxation." (116) Since Professor Surrey's article, most academics have called into question constitutional realization, and in some cases contended that it is no longer required, even though the Supreme Court has never overruled Macomber. (117)

Three years after Horst, the Supreme Court had another chance to overrule Macomber in a case with similar facts. (118) The case of Helvering v. Griffiths involved the issue of whether a pro-rata distribution of common stock to a common stock shareholder was a "dividend" under the Internal Revenue Code of 1939. (119) The taxpayer (a shareholder of Standard Oil Company) received common stock dividends in 1939 and did not include them as income on her return for that year. (120) Under the Internal Revenue Code of 1939 and its predecessor provisions, gross income included "dividends" under section 22(a), and section 115(f)(1) which stated, in relevant part, "A distribution made by a corporation to its shareholders in its stock or in rights to acquire its stock shall not be treated as a dividend to the extent that it does not constitute income to the shareholder within the meaning of the Sixteenth Amendment to the Constitution." (121) It was the Commissioner's position that it was time for the Supreme Court to finally put an end to Macomber based on the above statutory language and its administrative regulations. (122)

The Commissioner asserted the taxpayer had taxable "income" upon receipt of the common-on-common stock dividends. (123) The Supreme Court, however, disagreed after reviewing the statute's legislative history. (124) The statements of various members of Congress and Treasury officials evidenced that the above statutory language was intended to preserve the Macomber decision, not overrule it. (125) It was further intended to expressly acknowledge that not all stock dividends are nontaxable. (126) Such as in the case of Koshland v. Helvering, a pending case at the time, which held a distribution of common shares to a preferred stock holder did constitute a dividend, and thus taxable income to the stockholder. (127) Koshland was distinguishable, however, from Macomber in that it was a distribution of common stock on preferred stock. (128) Macomber dealt instead with a pro-rata distribution of common-on-common, and thus the relative interests of each shareholder remained unchanged (129) Some commentators have suggested that what Macomber really did was reinforce the concept of a corporation and its shareholders as two separate entities under tax law. (130) In Macomber, to tax the shareholders was to tax them on a pro-rata share of corporate earnings without any distribution to them of such earnings or change in their respective ownership. In Koshland on the other hand, the distribution of common shares changed the respective rights of the existing shareholders--something that could rise to the status of an event warranting realization.

The Supreme Court in Griffiths thus limited application of Macomber to pro-rata common-on-common stock dividends. (131) The Court held that section 115(f)(1) was designed by Congress to tax some stock dividends, but not all, as its predecessor provision under the Revenue Act of 1921 was too broad in that it excluded all stock dividends from taxation. (132) Despite this congressional move towards taxing some dividends, the Court acknowledged that the statute itself (and its legislative history) intended to preserve Macomber, and not tax all stock dividends. (133) With regard to the issue of whether Congress could constitutionally tax "Macomber type" stock dividends (e.g., pro-rata common-on-common) the Court dodged the question. (134) The Court stated, in relevant part,
  The Government says that the time has come when [Eisner v.
  Macomber] must be overruled, and that we should construe
  115(f)(1) as intended to tax the dividends here in question and thus
  to require reconsideration of that decision [a position shared and
  voiced by the dissenting opinion]. It should be observed that the
  question of the constitutional validity of [Eisner v. Macomber]
  is plainly one of the first magnitude, but this is not to say that it
  is presented in this case. Under our judicial tradition we do not
  decide whether a tax may constitutionally be laid until we find that
  Congress has laid it. Unless the tax asserted by the Commissioner
  has been authorized by Congress[ ] it fails of validity before we
  even reach the constitutional question. To reach that question we
  must decide whether Congress intended by [section] 115(0(1) to do
  what [Eisner v.  Macomber] squarely held that it could not. We
  cannot find that it did. (135)

In other words, because section 115(0(1) did not venture into taxing Macomber type dividends, the Court did not need to decide the constitutional question. (136) The Court did state though that the eases following Macomber such as Horst and Brunt? "undermined further the original theoretical bases of the decision." (137) Such has been the case even though the entire income tax system was constructed around realization, and such continues to play a significant role in determining income. (138)

Presumably, this academic blind spot is because a mark-to-market system is perceived by some academics as more equitable. Furthermore, it arguably violates principals of both horizontal and vertical equity. Horizontal equity requires taxpayers with similar incomes have similar tax liabilities, but this is not necessarily the case when realization is required. Because the realization requirement permits taxpayers to defer gains, a taxpayer invested in assets (although increasing in wealth economically) may have a lower tax bill versus a similarly situated taxpayer not invested in such assets. From a tax policy standpoint an ideal income tax system would also achieve vertical equity--i.e., taxpayers who earn more should pay more. But often those taxpayers invested in capital assets are the same taxpayers that earn more. Therefore vertical equity is violated because higher income taxpayers are more likely to defer gains compared to lower income taxpayers.

The realization doctrine has also been criticized as economically inefficient because it encourages investment in certain assets which defer gain, compared to assets generating income which may not necessarily appreciate (e.g., bonds, interest bearing assets, etc.). Professor Edward McCaffery, Chair in Law and Professor of Law, Economics and Political Science at the University of Southern California, has eloquently summarized tax planning for the wealthy in three words, "Buy, Borrow, Die." That is, there is no realization event on the acquisition of assets, none as they appreciate, nor when such appreciation is used as collateral upon which borrowing can be made and, of course, no realization upon death--earlier congressional efforts to impose realization on gifts and inheritances notwithstanding. Further, the decedent's heirs receive a stepped-up (or down) basis in the assets under section 1014. (139) They can then sell these assets without gain recognition using the proceeds to pay off the debts of the decedent that were secured by the very assets now being sold.

F. Hold Your Ponies, Realization is Still Breathing

A careful reading of Horst indicates the rule of realization was "founded on" administrative convenience, but it does not necessarily address its constitutional underpinnings. (140) Horst also did not necessarily state (or imply) the rule was intended to make matters convenient for Congress to determine ad hoc when a taxable event occurs. Construing constitutional income was reserved to the judicial branch in Macomber. Realization was arguably intended by the drafters of the Constitution as a device to make income administratively convenient to measure. It fixes an ending point in time to measure income, versus simply taxing increases in taxpayer wealth without any definitive ending point. In other words, perhaps Horst was simply making reference to the fact that the tax definition of income differs from economic income. The Horst court, as well as all subsequent judicial interpretations of Macomber, never once indicated Congress (or the Service) was free to do away entirely with realization.

The authors suggest Horst may have actually broadened the parameters of realization by applying it to tax avoidance transactions. If anything, Horst was a limited departure from constitutional realization to prevent tax avoidance. In 1993, Professor Ordower published an article questioning Professor Surrey's assertion that constitutional realization was finished. (141) A few other academics have also asserted such. (142) Professor Ordower rightfully stated in his article that the Supreme Court has never accepted the position that mere appreciation in the value of capital is taxable without more, and it has never retreated from its constitutional mandate of realization. (143) Although, even Professor Ordower did acknowledge that Congress has eaten away at the doctrine over the years by enacting various exceptions without much scrutiny. (144)

G. A New Definition of Income With Its Old Friend Realization

In 1955, the Supreme Court had another opportunity to shed some light on realization in another outlier transaction in Commissioner v. Glenshaw Glass Co. (145) In this case, the court instead decided to create an entirely new layer of phraseology to define constitutional income. (146) Glenshaw entailed two consolidated cases of taxpayers receiving money for exemplary damages for fraud and punitive damages for antitrust violations. (147) The issue before the court was whether the monies received by the taxpayers constituted gross income as "gains or profits and income derived from any source whatsoever" under section 22(a) of the Internal Revenue Code of 1939. (148) This was the same catchall language contained in the Revenue Act of 1916 and also at issue in Macomber. (149)

The taxpayers in Glenshaw argued their economic windfalls were not within the proper scope of the statute, and the statute's language should be read narrowly, as it was in Macomber, which required a severance from capital before realization. (150) The taxpayers stated the language of section 22(a) was only intended for "gain derived from capital, from labor, or from both combined" as mentioned in Macomber--not for exemplary or punitive damages. (151) The Court on the other hand, again backing down from Macomber, stated it served a useful purpose at the time for distinguishing gain from capital in the case of a stock dividend, but it was not meant to provide a "touchstone to all future gross income questions." (152) The Court next laid out its new standard for outlier gross income questions; namely, gross income exists when "we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." (153) Under this new language, the taxpayers had gross income upon receipt of the damage awards. (154)

Glenshaw may have distinguished itself from the court's prior definition of income, but nevertheless it retained realization in its new language, stating income must be "clearly realized" for such to exist. (155) Once again, the court failed to directly overrule Macomber, or address realization as a criterion for constitutional income. Furthermore, while the cases of Macomber, Bruun, Horst, and Glenshaw may have all wrangled with the outer limits of realization, they nevertheless required an identifiable and actual event to occur. For example, the transfer of the interest coupons was a "transfer" of an asset, the distribution of common stock on common stock was a nonevent as the taxpayer's interest remained unchanged (and thus no realization occurred), the receipt of punitive damages was clearly the "receipt" of income, and the repossession of a taxpayer's improved land after the termination of the lease was arguably an "exchange" of the unimproved property for improved (or at a minimum there was a "completion of the transaction"). Not one of these cases deemed realization on the taxpayer through a fictional disposition like the mark-to-market provisions of the Code do. Arguably, Bruun may have taxed unrealized appreciation, however, sections 109 and 1019 now eliminate such premature recognition from occurring.

H. Gains Must Still be "Derived From" and "Clearly Realized"

The statutory framework underlying realization initiates with the Sixteenth Amendment, which defines income as existing "from whatever source derived." (156) The Sixteenth Amendment was passed by Congress on July 2, 1909, and ratified on February 3, 1913. (157) Prior to 1913, the federal government relied predominately on customs and duties to finance its various operations. (158) The first federal income tax impacting individuals was not until 1861, which was imposed to finance the Civil War. (159) This tax was later repealed, however, and Congress waited almost thirty years before it enacted the Income Tax Act of 1894. (160) The Income Tax Act of 1894 imposed a tax on income over four thousand dollars at a rate of two percent "from any source whatsoever." (161) This income tax was later held unconstitutional in Pollock v. Farmers' Loan & Trust Co. (162) Pollock held that it was a direct tax on income and therefore was required to be apportioned among the several states according to their respective populations. (163)

An income tax apportioned among the states would be far too difficult to administer, as it would mean different taxpayers with the same income would be subject to different rates of taxation. President William Taft therefore encouraged Congress to amend the Constitution and pass the Sixteenth Amendment. (164) The members of Congress at the time were so upset with the Pollock decision that there was no real legislative debate over properly defining income. (165) In fact, there was little congressional debate at all over the amendment's passage. (166) The language of the Sixteenth Amendment is one sentence long and to the point stating, "The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration." (167)

Shortly after its ratification, Congress enacted what we now know as our first modern-day federal income tax, the Revenue Act of 1913 (which also taxed income from all sources), (168) There were then various amendments to the Act over the years as separate Revenue Acts, and finally, the Acts were codified into the Internal Revenue Code of 1939. The Internal Revenue Code of 1939 was later re-codified into the Internal Revenue Code of 1954. The Code of 1954, after the elimination of many "deadwood" provisions, was re-codified again into the current Internal Revenue Code of 1986. Nevertheless, with all of the various Acts (and re-codifications) a clearly delineated definition of income was never accomplished. Yet, realization has remained a requirement couched against the language of the Sixteenth Amendment since Macomber. Although, it has been commonly understood that the definition of income is extremely broad in scope; hence, the language "from whatever source derived." The fact that Congress never affirmatively defined income, however, is consistent with the majority opinion in Macomber, and that is the exact scope of constitutional income is a question reserved to the courts. In many respects, the amorphous concept of realization is therefore the only governor restricting Congress's ability to tax economic gains.

I. Laying the Bricks and Mortar For Realization

Section 61(a)(3) of the Code states gross income includes, "gains derived from dealings in property." (169) Section 61 and its accompanying regulations do not define "dealings in property." Although, Treasury Regulation section 1.61-6 does specify that gain realized on the "sale or exchange" of property is income, unless expressly excluded. (170) Therefore, under current law, clearly a sale or exchange is a "dealing in property." Gain is computed under section 1001 as the excess of a taxpayer's amount realized over the unrecovered cost basis or other basis of the property sold or exchanged. (171) Section 1001(a), which is the governor for computing a taxpayer's gain or loss in a transaction states,
  The gain from the sale or other disposition of property shall be the
  excess of the amount realized therefrom over the adjusted basis
  provided in section 1011 for determining gain, and the loss shall be
  the excess of the adjusted basis provided in such section for
  determining loss over the amount realized. (172)

Section 1001(a) on its surface does not appear to outright require realization as an element of an income, but rather, the statute merely assists in computing realized gain or loss. In other words, it is unclear as to whether or not section 1001(a) sets forth an expressed mandate requiring a realization event before gain or loss is realized under the Code or does it simply imply such. (173) Surely, according to Macomber the Constitution requires realization before a taxpayer has "income," but even Macomber has been watered down by subsequent cases into a cloud of confusion. Furthermore, the post-Macomber cases have tightly locked down the application of Macomber to its explicit facts (i.e., pro-rata common-on-common stock dividends). Now, because the holding of Macomber has been so severely restricted and bashed around by subsequent cases, realization as a constitutional requirement under case law also appears remaining only by implication. Of course it continues to stand as a matter of administrative convenience as contended by academics and economists. Yet, nevertheless, it endures implicitly interwoven throughout the Code, although not expressly required at any particular statutory juncture. Deemed realization on the other hand, finds refuge only in limited provisions in the Code, mostly all where tax avoidance is at issue.

Section 1001(b) defines a taxpayer's "amount realized" as the sum of any money received plus the fair market value of any property received. (174) Although not expressly mentioned in the statute, a taxpayer's amount realized includes any debt the taxpayer is relieved of (whether recourse or nonrecourse). (175) A taxpayer must then "recognize" any realized gain or loss under section 1001(c), unless another Code provision allows (or requires) nonrecognition (e.g., sections 1031, 351, 267, etc.). (176) What a taxpayer recognizes is essentially what a taxpayer is required to report, whether gain or loss. (177) Thus, realized gain is that amount received by a taxpayer in excess of basis, and realized loss is that amount which a taxpayer's adjusted basis exceeds the taxpayer's amount realized. (178)

The pivotal realization event is an actual "sale or other disposition" by the taxpayer, and as stated, the regulations provide that an exchange constitutes a "dealing" in property. Going all the way back to the Revenue Act of 1918 it too included gain from the "disposition" of property as income. (179) The regulations at the time also mentioned income on "gain realized." (180) The revenue laws of 1924 also discussed gain from a "sale or disposition" of property, and despite numerous statutory changes over the years, the language set forth in section 1001(a) computing and implying realization has remained relatively stable. (181) Meaning, mere accretions in value are generally not taxed until a triggering event occurs. Realization is the general rule.

Although section 1001(a) does not expressly refer to dealings in property, as does section 61(a)(3), it does provide such gains occur when there is a "sale or other disposition." A sale of course (and often times a disposition) severs the profit or gain from the capital exacting the very realization event required in Macomber. Outside of academia, the vast majority of business dealings in commerce fall within a sale (e.g., merchants selling goods, etc.), and thus, there is no academic inquiry into whether realization has in fact occurred. Neither the Code nor the regulations, however, define "other disposition," although it is now clear exchanges of property and property conversions into cash suffice. (182) The regulations state, in relevant part, a sale or other disposition includes, "the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent." (183) The regulations do not define materially different, which as discussed below was eventually resolved by the Supreme Court. In other words, if property is not materially different when exchanged, no realization transpires as the taxpayer is not in a different position than prior to the exchange (similar to a pro-rata stock dividend). (184)

J. Another Foregone Opportunity to Overrule Macomber

After Horst, the Supreme Court waited over fifty years before mentioning again that realization was premised on "administrative convenience." (185) The Supreme Court cases Cottage Savings Ass 'n v. Commissioner and United States v. Centennial Savings Bank (186) addressed the question of "materially different" properties, and whether the Commissioner had exceeded its delegated authority when it promulgated Treasury Regulation 1.1001-1, which requires that properties be materially different before realization is triggered. The Court in Cottage Savings Ass 'n stated that the requirement had existed in the regulations since 1934, survived all of the subsequent changes to the statute, and therefore such was a reasonable interpretation of the statute. (187) In both cases, however, rather than looking at the underlying economic substance of the properties at issue (which would have been the logical next step after Macomber), the Court instead adopted a more formalistic approach to defining materially different, stating properties differ when their respective possessors enjoy legal entitlements that are different in kind or extent. (188) This became known as the legal entitlements test. (189) Under this formalistic interpretation, the vast majority of exchanges trigger realization when anything other than identical properties are transferred. (190) Although Cottage Savings Ass 'n entailed the issue of whether properties were materially different, the Court nevertheless had another opportunity to overrule Macomber. But unfortunately, when discussing Macomber, the Court simply stated that its successor cases merely "refined" the concept of realization in the context of property exchanges. (191)

Rather than seizing the opportunity to overrule Macomber, the Court yet again, in dictum, only grazed the issue of constitutional realization. (192) The Court acknowledged that the concept of realization is "founded on administrative convenience" (193) and the Court said there should be no more of a standard than is necessary for realization to satisfy its administrative purposes. (194) In other words, the bar set for realization should be a workable standard for taxpayers and the Service. (195) According to the Court, under an accretion system of taxation, "taxpayers and the Commissioner would have to undertake the 'cumbersome, abrasive, and unpredictable administrative task' of valuing assets on an annual basis to determine whether the assets had appreciated or depreciated in value." (196)

The Commissioner argued for a more complex test to determine "materially different," but the Court disagreed. (197) Under the Court's formalistic definition of "materially different," a realization event had in fact occurred. The taxpayer was therefore permitted to recognize its losses incurred when it exchanged its participation interests in various mortgages with another lender. By requiring that the mortgages be materially different for realization, and thus income or loss recognition, the Court reinforced the requirement of realization, not weakening it, as suggested by some. The Cottage Savings Ass 'n case was the Supreme Court's last major review of the realization doctrine. Only a few lower federal and state courts have even mentioned that realization was founded on administrative convenience.198 Furthermore, exactly what "founded on" administrative convenience means remains a mystery. Does it mean realization is not rooted in the Sixteenth Amendment? Is the Supreme Court attempting to detach realization from income as defined for constitutional purposes? Both Cottage Savings Ass 'n and Horst did not provide any insight in this regard. Although the legislative history is slim, is it not possible that the drafters of the Sixteenth Amendment contemplated realization as a prerequisite to income? Furthermore, in many respects, the courts are now locked-in to the Macomber analysis, as stated in Macomber realization is expressly provided for in the derived from language of the Sixteenth Amendment. It is also codified by implication in sections 1001 and 61, and discussed in the regulations. Our entire income tax system has evolved around it, so why should we depart from it now?

While the determination of taxable income is clearly distinctive from net income for generally accepted accounting principles, (199) the determination of taxable income is much more closely aligned to the determination of income under accounting principles than under economic ones. Accounting principles generally also require an event rather than the mere passage of time for income recognition. There are exceptions though, particularly in determining the balance sheet values of marketable securities, or asset impairments. But again, these concepts are more closely aligned with tax concepts of realization. For example, the M-1 and M-3 schedules on the corporate income tax return reconcile taxable income to financial statement income, not to economic income. (200) The calculation of earnings and profits, however, can be more muddled by introducing economic concepts as well.

The courts and the Service have also held that income may be realized from barter exchanges involving property swaps, the exchange of services, as well as the right to use certain property. (201) A "disposition" has generally been understood to include any transfer of property, regardless of whether or not consideration is received by the taxpayer (e.g., foreclosure, condemnation, fire, etc.). (202) Black's Law Dictionary defines a disposition as "[t]he act of transferring something to another's care or possession, esp. by deed or will; the relinquishing of property." (203) The inherent appreciation or depreciation in the transferred asset does not generate income or loss to the transferor. (204) The phrase "sale or other disposition" is largely concerned with quid pro quo transactions between taxpayers. (205) As explained previously, while a gift or inheritance conceptually is a "disposition" of property in the ordinary sense of the word, the corresponding realization event, i.e., the disposition, has historically been ignored by the Service and the courts. (206)

With regard to gifts, the carryover basis section 1015(a) further evidences the congressional assumption that gift transfers are not taxable events. (207) Furthermore, as far as the donee is concerned, section 102(a) excludes from income the value of the property received by gift, bequest, devise or inheritance. (208) Gifts will be treated as dispositions triggering realization for the donor, however, when a taxpayer transfers the fruits of income-producing property (e.g., the interest, rents, dividends, etc.), but not the underlying tree itself. (209) In effect, the Service and the courts will deem realization on a disposition, which would normally be ignored because the taxpayer had a tax avoidance purpose (i.e., the assignment of income).

There are also a few other situations where a gift may be viewed as a realization event, such as disguised sales where the donor lines up a sale of appreciated property and transfers the property to the donee shortly before the sale for the donee to complete. (210) Other situations include gifts of property subject to debt which the donee assumes, (211) taxing political contributions of appreciated property under section 84, (212) gain on gifted installment obligations under section 453B(a), (213) and gifts of income in respect of a decedent under section 691(a)(2). (214) Similar to Horst, transactions in which a donor of property lines up a sale transaction and then transfers the property to a donee who is expected to complete the transaction is a form of tax avoidance, as the donor is attempting to avoid the built-in gain or loss on the asset. Of course this type of transaction is clearly on the outer limits of the tax avoidance spectrum. When a taxpayer transfers property subject to debt (particularly nonrecourse debt) that is assumed by the donee, ignoring the disposition would be ignoring the tax principles discussed in Tufts (215) and Crane. (216) Of course a gift of an installment obligation is an assignment of income, as well as gifts of income in respect of a decedent. All of the aforementioned scenarios therefore deem realization only for the limited circumstance of preventing tax avoidance. (217)


A. A Mark-to-Market Election for Some, But Not All

In theory, without Macomber, the Code could have utilized the economist's definition of income, embodying accretion principles. Instead, tax law intentionally chose realization as a prerequisite to income recognition--constitutionally required or not. There are, however, a few circumstances where realization is deemed to occur, even though the taxpayer has not transferred, sold, exchanged, or otherwise disposed of the asset generating the gain or loss. These deemed realization events in the Code are either voluntary or involuntary. Voluntary realization is generally achieved via a taxpayer election. Regardless of whether deemed realization is voluntary, it is typically accompanied by recognition of gain or loss, meaning one does not elect deemed realization, and then haphazardly fall within a nonrecognition provision such as sections 1031, 1033, 351, 721, etc. (218) This is because realization is deemed to have occurred on account of legislative action, regardless of whether it was intended as a taxpayer punishment or privilege. However, this is not the case for realization events that do in fact occur, as there are a number of nonrecognition provisions permitting taxpayers to avoid recognizing realized gains and losses. (219) Of course a nonrecognition provision merely defers gains and losses until a later point in time. (220) In a nonrecognition transaction, the realization event is simply ignored, and unrealized gain or loss is postponed until a subsequent disposition (i.e., another realization event whether actual or deemed). Such deferral, and the blind eye at the realization event, is often allowed by Congress to encourage the freeing up of trade or business and investment assets. Thus, avoiding the dreaded "lock-in effect" scholars criticize as one of the inherent flaws of realization. Theoretically, nonrecognition is a mere continuance of the taxpayer's initial investment, and not an entirely new investment, even though the underlying asset has changed (e.g., stock exchanged for property in a section 351 transaction). There are specific permanent exclusions of realized gain from income recognition, such as the exclusion of certain gain on the sale of a principal residence. (221) These exclusions are rare and clearly exist as a matter of legislative grace.

B. Election for Traders in Securities, Commodities Dealers and Commodities Traders

Under section 475 of the Code, traders in securities and commodities dealers and traders may elect to utilize mark-to-market accounting. (222) This is the case even though the constitutional quagmire of realization has not been resolved. Section 475(f) provides that traders of securities may elect to recognize gain or loss on any security held in connection with the taxpayer's trade or business as if the security were sold for its fair market value on the last business day of the taxable year. (223) If the security is later actually sold the taxpayer is to make proper adjustment to the gain or loss recognized to account for the previous deemed realization event. (224) Under section 475(f)(2), a commodities trader can also make a similar election for identical treatment under section 475(f)(1). (225) A dealer in commodities is also permitted to elect mark-to-market accounting. (226) Accordingly, the dealer in commodities is treated in the same manner as a dealer in securities under section 475(a). (227) A dealer in securities, however, does not have the option of electing mark-to-market treatment, but is rather required to do so under section 475(a). (228) Furthermore, deemed realization occurs with regard to any security held by a dealer in securities, which is held at the end of the taxable year and is not inventory in the dealer's hands. (229)

C. Investors, Dealers and Traders Distinguished

When a transaction involves taxpayers holding securities, they are classified into three different types of taxpayers under the Code: investors, dealers, or traders. Investors are your typical taxpayers holding and selling securities. An investor's activities are limited to occasional trades out of the investor's own personal account. An investor's level of trading activity does not rise to that of a securities trader or dealer. Moreover, the trading of securities is usually not an investor's primary source of income (although an investor may derive most of his or her income from investments and still be classified as such). (230) Investors purchase securities hoping to earn a return in the form of interest, dividends, or long-term capital gains. Because an investor is not engaged in a "trade or business" any investment expenses are itemized deductions on Schedule A (subject to a two percent adjusted gross income floor). An investor's investment interest expenses incurred (although not subject to the two-percent floor), are limited to the investor's net investment income for noncorporate taxpayers. (231) I With regard to gains and losses, because an investor holds securities for investment purposes, any gains and losses on the sale of securities is long-term or short-term capital gain or loss (depending on the holding period). (232) Thus, a security is a "capital asset" in an investor's hands, because it is not expressly excluded from the definition of a capital asset under section 1221. (233) An investor in securities does not have the option of electing mark-to-market taxation, but rather must wait until the actual sale or other disposition to trigger realization. (234)

A trader in securities on the other hand, may elect deemed realization. (235) A trader in securities, known informally as a "day trader," typically trades from his or her own brokerage account similar to an investor. A trader is distinguished from an investor, however, based on the frequency of the trader's activities, which are substantial, frequent, regular, and continuous. (236) Unlike an investor, a trader does not look to interest, dividends, and long-term gains as a source of profit, but rather, a trader seeks profit from the short-term value changes in securities from market-swings. (237) Similar to a dealer in securities, a trader's activities rise to the level of a trade or business, and thus, a trader's expenses are mostly above-the-line deductions reported on Schedule C. When securities are sold, because a trader does not hold securities out for sale to "customers," but instead trades from his or her own account, any gain or loss from such sales is capital in nature. (238) In other words, the securities are not "inventory" in the trader's hands generating ordinary income or loss. Furthermore, because a trader does not hold onto a security for very long (given the nature of day trading), gains and losses are almost always short-term capital gains and losses. (239) If a trader has net short-term capital gains they are treated like any other item of ordinary income (after of course being reduced by any net long-term capital loss). (240) Net short-term capital losses unfortunately cannot, however, create a net operating loss for a trader, and they also only offset ordinary income for individual taxpayers to the extent of $3000 (with any excess losses carried forward). (241)

D. No Constitutional Objections from Traders in Securities and Commodities

Because of the limitations on offsetting short-term capital losses against ordinary income, traders with significant losses may find a mark-to-market election beneficial. A trader does not usually hold a security for more than one year and thus preferred long-term capital gain treatment is not available anyway. (242) If a trader elects under section 475(f), all of the taxpayer's gains and losses are ordinary in character. (243) A trader in securities is thus permitted to transmute what would normally be short-term capital gains and losses into ordinary gains and losses. This statutory generosity is a highly unusual occurrence in the Code; in that, traders are permitted by election accretion taxation and the modification of the character of their gains and losses. The election may also apply separately for each trade or business and applies to the year of election, and all subsequent years, unless revoked with consent of the Service. As for traders in commodities and dealers in commodities, they are also treated in a similar manner. (244) A trader in securities (or a dealer or trader in commodities) may desire to make an election to claim ordinary losses not only against current ordinary income, but to create a net operating loss which may be carried back two years and forward twenty. (245)

The taxpayer also does not have an "undeniable accession to wealth" over which the taxpayer has "complete dominion." Yet, Congress nevertheless enacted elective accretion taxation for traders in securities and commodities and dealers in commodities. Because deemed realization is not involuntary, but rather voluntary, there are no constitutional issues with such, and taxpayers and the Service are free to agree among themselves when income should and should not be taxed.

In terms of administering such a system (which more closely follows economic income), the administrative burden is not necessarily increased, given the activities of traders in securities and commodities. As absent an election, traders already must account for numerous sales and exchanges occurring throughout the year. Therefore, mark-to-market taxation poses no more of an administrative burden than existed previously before the election. With regard to political feasibility, because the election is voluntary and advantageous to the taxpayer, presumably there was no political contention with its enactment. Valuation issues are also not a concern because securities and commodities are generally publically traded. Liquidity difficulties also pose no issue for the taxpayer because the election is usually made when the taxpayer is experiencing substantial losses. Furthermore, even without considering losses, a trader is nevertheless going to experience a similar amount of gain absent an election, given the nature of the business. Ironically, although a trader in securities holds identical assets to that of an investor (i.e., capital assets), they are treated differently because Congress prefers the unique posturing of the trader over of the investor. Some scholars have criticized this inequitable treatment granted to traders over other businesspersons. (246)

E. The Election for Securities in Passive Foreign Investment Companies

Another area of tax law that involves elective realization entails the passive foreign investment company (PFIC) rules. Generally, U.S. investors in domestic mutual funds are taxed currently on the fund's domestic income because a domestic fund must distribute at least ninety percent of its income each year to avoid U.S. taxation at the fund leve1. (247) In contrast, U.S. investors in foreign mutual funds and the foreign mutual funds themselves were historically able to avoid U.S. taxation. The fund itself avoided (and continues to avoid) U.S. taxation as a foreign corporation with no U.S. source income. The U.S. investors avoided U.S. taxation because the fund paid no dividends. Despite the fact that the underlying income of these funds were, by definition, passive in nature, both controlled foreign corporation (CFC) status and the old foreign personal holding company (FPHC) rules under sections 551-558 were avoided because the ownership was widely dispersed and each investor held a relatively small percentage in the fund. (248) A U.S. investor could, therefore, avoid the realization and recognition of income until the stock was ultimately sold, triggering capital gain or loss at the time of sale.

In 1986 Congress enacted the PFIC regime (sections 1291-1298). (249) This legislation was enacted specifically to combat these tax avoidance schemes used by taxpayers (i.e., foreign investment companies and foreign mutual funds). (250) The PFIC rules apply to any foreign corporation that satisfies the statute's asset test or income test, regardless of the percentage of stock held by the U.S. taxpayer or of the aggregate holdings of all U.S. taxpayers in the foreign corporation. Under the income test, a foreign corporation is a PFIC if seventy-five percent or more of the corporation's gross income for the year is foreign "personal holding company income." Foreign personal holding company income is defined as it is for subpart F purposes. (251) Furthermore, section 1297(c) prevents a foreign company from diluting its gross passive income earned by owning subsidiaries. (252) Section 1297(c) states that in the case of a foreign corporation owning directly or indirectly at least twenty-five percent of the value of the stock of another corporation, that corporation will be treated as if it earned a proportionate share of such corporation's income. (253)

Under the asset test, a foreign corporation is a PFIC if the average market value of the corporation's passive assets during the taxable year is fifty percent or more of the corporation's total assets. (254) Section 1297(e)(2) provides that an electing corporation determines the asset test based on the adjusted basis of its assets, rather than their fair market value. (255) Passive assets are assets that produce passive income (e.g., dividends, interest, rents, annuities, and royalties). Similar to the income test, a foreign corporation that owns directly or indirectly at least twenty-five percent by value of the stock in another corporation is treated as if it owned directly a proportionate share of that corporation's assets. (256) Special formulas also exist for calculating the fair market value of the assets of a publicly traded corporation.

The PFIC itself is never subject to taxation in the US, but rather its undistributed earnings are subject to U.S. taxation under one of two methods, each of which is specifically designed to eliminate the benefit of deferral. Under the Qualified Electing Fund (QEF) method, shareholders can elect to be taxed currently on their pro-rata share of the PFIC's earnings and profits (E&P). The shareholder's income inclusion is traced to the underlying income that generated the PFIC's E&P and is taxed accordingly (i.e., capital, ordinary, etc.). (257) Should a taxpayer be subject to both the PFIC rules and the subpart F income rules, income inclusion is determined under the subpart F rules. (258) In other words, subpart F trumps the PFIC rules. The income included by a taxpayer making a QEF election increases the taxpayer's basis in the PFIC stock. That basis is correspondingly reduced to the extent subsequent distributions are derived from previously taxed income. (259) Domestic corporations otherwise eligible for a section 902 deemed foreign tax credit are eligible for the credit on the income generated by their QEF election. (260)

The second method of taxing PFIC earnings applies to U.S. investors who did not make a QEF election. Nonelecting taxpayers defer income recognition on their pro-rata share of PFIC income until an "excess distribution" is made by the entity. An excess distribution is comprised of any gain realized on the sale of PFIC stock (261) and any actual distribution made by the PFIC, but only to the extent the total distribution for the year exceeds 125% of the average actual distribution received over the three preceding taxable years, or less depending on how long the stock was held. (262) The amount of the excess distribution is treated as if it had been realized pro-rata over the holding period of the PFIC stock and, therefore, the tax due is the sum of the deferred yearly tax amounts, calculated at the highest tax rates in effect for those years, plus interest. (263) The interest rate is the applicable federal short-term rate plus three percent. (264) From the taxpayer's standpoint, it is almost always beneficial to make the QEF election versus taxation on any excess distributions. The election therefore is, in essence, a voluntary realization event somewhat similar to the election made by traders in securities and commodities and commodities dealers. In another way, however, it also has an element of deemed realization similar to the other instances discussed in this article, as it was enacted to prevent tax avoidance and if it is not made the tax consequences usually are more severe.


A. Penalizing Certain Accumulations of Corporate Earnings

Since the enactment of the first modern day income tax system in 1913, taxpayers have devised various tax strategies to avoid realization. To capture such outlier transactions, Congress has enacted deemed realization provisions and provisions penalizing taxpayers (with a surtax) on the accumulation of certain accumulated but undistributed income. In the past, when corporate tax rates were much lower than individual income tax rates, wealthy taxpayers were motivated to shift their income producing assets to closely held corporations (the so called "incorporated pocketbook") so that income could accumulate at the corporate level, exposed only to the lower corporate rates. (265) Congress quickly caught on to this tax avoidance strategy and enacted legislation to combat such tax deferral.

The first statute addressing accumulated corporate earnings was contained in The Revenue Act of 1913. (266) Under this Act, shareholders were required to report the income of a corporation on their individual income tax returns if the corporation was "formed or fraudulently availed of" for tax deferral purposes. (267) Before the Revenue Act of 1913, there were various legal precedents taxing undistributed profits dating back to at least 1864 on "gains and profits of all companies, whether incorporated or [not were to] be included in estimating the annual gains, profits, or income of any person entitled to the same, whether dividend or otherwise. (268) But there was no permanent legislation until after the passage of the Sixteenth Amendment.

As stated above, the Act deemed realization on the accumulated earnings of a corporation upon its shareholders when the entity was fraudulently formed (or availed of) to avoid taxation.269 The earnings of the entity were taxable to the shareholder "whether ... distributed or not." (270) Under the Act, the fact that a corporation was a mere holding company, or that gains and profits were accumulated beyond the reasonable business needs of the entity, was prima facie evidence that the corporation was fraudulently formed to escape taxation, (271) provided the Secretary certified in his opinion that the accumulation of earnings was unreasonable for the purposes of the business. (272) In 1918, Congress deleted "fraudulent" from the provision (273)

After the Supreme Court case of Macomber, the constitutionality of accretion taxation on the shareholder was called into question, and thus Congress decided to abandon the shareholder level tax altogether, imposing it directly on the infringing corporation as a penalty for accumulating earnings. (274) Congress thus eliminated the shareholder level tax in 1921, and levied a surtax directly on any corporation "formed or availed of to avoid taxation. (275) In 1924, Congress also eliminated the certification requirement imposed on the Secretary. (276)

Nevertheless, despite these numerous legislative changes taxpayers were still escaping realization. (277) In several high profile cases, taxpayers were accumulating substantial amounts of earnings and prevailing on the contention they were "innocent" of any intent to avoid the surtax. (278) One of the more blatant examples of such was the Third Circuit U.S. Court of Appeals case of National Grocery Company v. Helvering. (279) In this case, the company had significant accumulated earnings, yet nevertheless was found innocent of tax avoidance. (280)

In reaction, Congress tried again in 1936 to resolve the statute's ineffectiveness. (281) In 1938 Congress amended the statute yet again, by providing that an accumulation of earnings "beyond the reasonable needs of the business" resulted in tax avoidance, "unless the corporation by the clear preponderance of the evidence shall prove to the contrary." (282) Further amendments resulting in revisions to the test were made in the Revenue Act of 1954, and in subsequent amendments, which finally arrived at the standard currently used in the Code. (283) Nevertheless, the congressional objective behind deeming realization at the shareholder level, and penalizing corporations accumulating earnings beyond their reasonable business needs, has always been a fight against taxpayers trying to avoid realization. (284)

B. Tax Avoidance with Personal Holding Companies

In 1934 Congress enacted legislation to combat taxpayers avoiding the accumulated earnings tax through the use of "personal holding companies." (285) Corporations would escape the application of the accumulated earnings tax at the entity level by making partial distributions of the company's earnings and by claiming the company needed its remaining undistributed earnings for the business. (286) In light of this perceived abuse, Congress enacted the personal holding company (PHC) tax regime. (287) This regime taxed undistributed earnings regardless of why the corporation was formed or the purpose behind the company's accumulated earnings so long as the income was derived from certain statutorily defined activities and certain statutorily defined corporations. Corporations subjected to this regime were exempted from the accumulated earnings tax regime.

A PHC was defined in the Revenue Act of 1934 as any corporation, if eighty percent or more of the corporation's income was derived from certain passive-type income (e.g., dividends, interest, royalties, annuities, etc.) and at any time during the last half of the taxable year, more than fifty percent of the outstanding stock was owned directly or indirectly by five or fewer individuals. (288) The PHC rules were the beginning of a congressional focus on "passive" income (compared to active and passive as before) as PHCs derived most of their income from passive sources. The PHC rules were a direct reaction to wealthy individuals holding income-producing assets that were predominately passive in controlled corporations. As discussed below, taxpayers eventually devised more clever tax avoidance strategies by placing their monies in "foreign incorporated pocketbooks." Unlike the accumulated earnings tax, which is balance sheet based and looks to the incremental earnings of a corporation regardless of how derived, the PHC tax is income based and depends on the type of income earned. Both taxes though are levied at the corporate level.

The definition of PHC income now requires (since 1964) that at least sixty percent of a corporation's adjusted ordinary income (AOGI) constitute PHC income. (289) The purpose of the AOGI standard was to more precisely distinguish between a corporation's active business income and its passive investment income. Certain categories of income, such as interest, rents, and royalties can, in many instances, be either active or passive, depending on the facts and circumstances. (290) While the accumulated earnings tax and the PHC tax are imposed at the entity level, the now-repealed foreign personal holding company (FPHC) tax regime imposed it at the shareholder leve1. (291) The "tax" at the entity level under the accumulated earnings tax and PHC regimes is imposed as a type of surtax on the corporation's earnings. Rather than deeming a realization event, these statutes are raising the tax rate on these corporations because they failed to have a timely realization event. To avoid tax at the entity level there must be a realization event. Shareholders may, however, elect to ignore the entity liability by either distributing the accumulated earnings as dividends or by deeming realization on themselves under section 565 (i.e., a "consent dividend"). (292)

This election permits shareholders to agree to treat a specified portion of the corporation's E&P as a dividend even though no actual distribution is made. The consent dividend also constitutes a dividend eligible for the section 561 deduction for dividends paid. (293) This deduction reduces the amount of corporate income subject to the PHC tax (294) and the amount of accumulated income subject to the accumulated earnings tax. (295) The consent dividend must be allocated pro-rata among the shareholders that own consent stock on the last day of the taxable year. (296) The amount consented is treated as if it had been distributed in money to the shareholders on the last day of the corporation's taxable year, and then contributed back into the corporation as a contribution of capita1. (297) The election shifts the liability from the corporation to its shareholders, converts undistributed earnings and profits to capital, and increases the shareholders' basis in the corporate stock.

C. Let's Take the Personal Holding Company Overseas

Wealthy taxpayers soon discovered that, rather than forming a domestic corporation, they could set up a foreign corporation to hold passive income generating assets. Because the foreign corporation was not a "domestic corporation," its earnings would not be subject to U.S. taxation, until of course, the earnings were repatriated as dividends. Thus, a U.S. taxpayer's foreign shares would appreciate with unrealized gain as the entity retained its accumulated earnings outside the taxing jurisdiction of the United States. The foreign entity might be subject to a tax on its earnings in a foreign jurisdiction, but historically these entities were established in tax haven countries with little or no income tax. In response to this perceived loophole, Congress enacted the FPHC rules in 1937. (298)

It was not necessarily the shareholder level tax Congress found offensive, but rather that the entity earnings were placed outside of the taxing jurisdiction of the United States. Thus, Congress felt it appropriate to accelerate realization on the entity's earnings by treating them as constructive dividends to its U.S. shareholders. (299) The legislative history of the FPHC statute indicates Congress was concerned about tax evasion, particularly with some of America's wealthiest families escaping U.S. taxation with foreign incorporated pocketbooks. (300) These taxpayers quickly learned, however, they could continue to avoid U.S. taxation and the FPHC rules, by ensuring that the ownership test described below was not met. As long as the entity was not owned directly or indirectly by five or fewer U.S. shareholders, FPHC classification was avoided.

Before its repeal by the American Jobs Creation Act of 2004 (AJCA), (301) a U.S. shareholder of a FPHC had to include in income a pro-rata share of any of the undistributed income remaining with the foreign corporation at the end of its taxable year. The tax was levied at the shareholder level, unlike the PHC tax. The reasoning behind such was to prevent tax avoidance. As with the PHC rules, the FPHC rules required the subject corporation to satisfy a two-part test. (302) The first part provided that at least sixty percent of the corporation's gross income had to consist of "foreign personal holding company income," which included interest, rents, royalties, dividends, certain sales of stocks and securities, and certain personal services provided by the shareholders of the entity. (303) The second part required at least fifty percent of either the total voting power or total value of the stock of the corporation be owned directly or indirectly by five or fewer individuals that were U.S. citizens or residents. (304)

Similar to the PHC income tax rules, these provisions could apply to the shareholders of publically traded corporations if the requisite ownership and income tests were satisfied. The application of the FPHC rules was an unexpected and badly received surprise to U.S. shareholders of public domestic corporations (the application of the PHC rules still causes an equal surprise to the public domestic corporations it applies to). To make matters worse, there were also numerous coordination issues involved with determining how to tax income subject to the anti-deferral rules of the PHC regime, the subpart F income regime, and the FPHC regime under former sections 551-558. (305) The primary reason for the repeal of the FPHC rules was their obvious overlap with the other anti-deferral regimes. Nevertheless, realization is forced upon the taxpayer in all cases because of a congressional reaction to perceived tax avoidance.

D. The Subpart F Anti-Deferral Regime

Another area of tax avoidance (i.e., unwarranted tax deferral) and deeming realization upon shareholders of undistributed corporate earnings involves the subpart F income regime. The rules applicable to controlled foreign corporations (CFCs) are located in subpart F of part III of subchapter N of the Code and are, accordingly, commonly referred to as the "subpart F rules." (306) It was in 1962 when President John F. Kennedy introduced the subpart F regime that would forever alter the landscape of international taxation. The subpart F rules did not change the general rule that foreign source earnings of a foreign corporation are not subject to U.S. taxation (with the exception of "effectively connected income" with a trade or business in the U.S. under section 864(c)). (307) Rather, subpart F casts its net of taxing jurisdiction over a foreign corporation's U.S. shareholders, deeming realization on the entity's undistributed earnings upon its U.S. shareholders. This is similar in concept to the shareholder tax previously imposed by the FPHC rules but including a wider range of income and a different ownership test.

The starting point for any discussion of subpart F is the CFC. A CFC is defined in section 957(a) (308) as a foreign corporation with more than fifty percent of its total combined voting power or value owned by "U.S. shareholders." A U.S. shareholder is defined as a U.S. person (309) owning ten percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. (310) When applying the subpart F provisions, stock owned directly and/or constructively is taken into account under section 958. (311)

The end effect of subpart F is to require U.S. shareholders to report their pro-rata portion of the CFC's undistributed "subpart F income." Accordingly, the amount imputed on a U.S. shareholder under section 951 is indirectly adjusted to exclude any amounts actually distributed by the corporation. (312) The imputed income is first calculated without any reduction for actual dividend distributions. Section 959, however, prevents actual distributions from being taxed twice by classifying them as previously taxed E&P and providing that such earnings are considered as distributed first when actual distributions are made. (313) To the extent that undistributed earnings are imputed to the shareholder, they increase the shareholder's stock basis under section 961. (314) The shareholder's stock basis is then reduced as distributions are made from previously taxed E&P. These rules are somewhat similar in operation to the rules applicable to S corporations.

Constructive dividends attributable to U.S. shareholders under section 951 fall into two categories. The first category looks to where the earnings of the CFC are invested (i.e., section 956 investments in U.S. property). (315) CFC investments in U.S. property and subsequent increases in those or other investments in U.S. property are treated as constructive dividends limited by the amount of the CFC's expenses. The other category of constructive dividend is based on the type of earnings of the CFC (i.e., statutorily defined classes of subpart F income).

Subpart F income is defined as the sum of: (1) insurance income (defined in section 953); (2) foreign base company income (under section 954); (3) certain international boycott income; (4) illegal bribes and kickbacks; and (5) income from certain countries defined in section 901(j). (316) "Foreign base company income" includes foreign personal holding company income, foreign base company sales income, foreign base company service income, and foreign base company oil related income. (317) It should also be noted that a constructive dividend includes the withdrawal of previously excluded subpart F income from qualified investments in certain foreign base company shipping operations. (318) The foreign personal holding company income component of foreign base company income is defined in section 954(c) to include certain dividends, rents, royalties, and property transactions. (319) While not identical to the now repealed, foreign personal holding company income rules, the section 954(c) definition is similar to old section 553, which defined foreign personal holding company income for section 552 purposes. (320) Furthermore, the definition of PFIC income contained in section 1297(b)(1) is made by direct incorporation of the definition contained in section 954(c). (321) The overlaps are obvious. (322)

As far as the constitutionality of forcing realization (i.e., constructive dividends) upon U.S. shareholders, the Second Circuit Court of Appeals addressed the issue twice. In the case of Garlock Inc. v. Commissioner, the Second Circuit held that section 951 was constitutional and stated that the taxpayer's constitutional assertion bordered on "frivolous" in light of its prior decision in Eder v. Commissioner. (323) In Eder, the Second Circuit addressed the constitutionality of deeming realization upon the U.S. shareholders of certain FPHCs (to which subpart F is similar). (324) The court held that taxing the U.S. shareholders on their portion of the undistributed earnings of certain Columbian corporations was constitutional even though Columbian law restricted U.S. shareholders from receiving income in excess of $1000 per month from these entities. (325) Columbia's restriction on the corporation's ability to distribute its earnings posed no bar to Congress's ability to tax undistributed and restricted earnings. The taxpayers in Garlock contended the constitutional issues in Eder were waived. The court, however, disagreed. (326) The Garlock court in a footnote particularly noted Judge Frank's explicit reference to and paraphrase of Heiner v. Mellon, (327) to the effect, "Whatever may be the continuing validity of the doctrine of Eisner v. Macomber . . . as applied to the facts in this case it has no validity under Mellon." (328) Although the constitutionality of subpart F and its deemed realization now remains relatively stable, undeniably the statutes were implemented to prevent unwarranted tax deferral.

In the Tenth Circuit Court of Appeals case of Estate of Leonard E. Whitlock, the constitutionality of section 951(a) was raised. (329) At issue were the section 956 U.S. investment property rules and the mandate to treat such investments when made by a CFC as a constructive dividend to its shareholders. (330) The court unanimously found the taxpayer's contention that the provision violated the Fifth Amendment and the provisions relating to direct taxes under the Constitution to be without any merit. (331) With regard to the due process claim, the court determined the contention had no merit because the Supreme Court had previously held otherwise as to corporate accumulated earnings in National Grocery Co. (332) The court also found no merit in the taxpayers' direct-tax contention that the increased earnings provision was unconstitutional when the court "considered together" the provisions of Article I of the Constitution, the Sixteenth Amendment, Glenshaw Glass Co., Macomber, and Pollock. (333)

E. The Constitutionality of Penalizing Entities

In Helvering v. National Grocery Co., the Supreme Court questioned whether the surtax on accumulated earnings was constitutional.334 The Court, however, made no mention of realization as a constitutional prerequisite for "income," as the surtax was imposed as a penalty on the taxpayer for the failure to cause a realization event (i.e., a disposition). Nor did the court mention Macomber. Rather, the taxpayer in National Grocery Co. argued that the accumulated earnings tax was unconstitutional under the Sixteenth Amendment because it was a direct tax on the taxpayer's "state of mind," which was to prevent the imposition of the tax on its shareholders by permitting gains and profits to be accumulated instead of being divided or distributed. (335) The Court disagreed stating that the tax was "upon the net income of such corporation." (336) The taxpayer's state of mind merely determined the incidence of an income tax, just as it does in other situations such as additional taxes for fraud with the intent to evade taxation. (337)

Generally speaking, a surtax is either a tax levied on a tax, or an additional tax levied on taxable income (usually when it exceeds a specified statutory amount). A broadly levied surtax was imposed to help finance the Vietnam War during the Johnson administration. The surtax essentially consisted of calculating one's ordinary income tax and then adding an additional ten percent to it. During World War II, there was a war profits tax that was also referred to as an excess profits tax. This excess profits tax was reinstated during the Korean. War. In recent years, there has been an unsuccessful push to impose an excess profits tax on oil companies. Typically these additional surtaxes are based on income level.

The tax levied by the accumulated earnings tax regime of sections 531 to 537 imposes a fifteen percent tax on accumulated income as defined in section 535. (338) The tax itself is imposed by section 531, and the rate is equal to the current tax imposed on certain dividends received by U.S. individual taxpayers. (339) Section 532(b) makes it clear that neither PHCs nor PFICs are subject to this tax. (340) Accumulated taxable income for this purpose is reduced by any dividends either actually paid or considered paid via the consent mechanism of section 565. (341) While the tax, like the PHC tax, is assessed at the entity level, it can be shifted to the shareholder by election. (342) Rather than being construed as deemed realization events, the accumulated earnings tax (and the PHC tax) is a tax or penalty on nonrealization events (i.e., it is a penalty assessed on the earnings of a corporation when not distributed and thus not realized by its shareholders. It is not assessed when dividends are in fact paid and thereby realized.).

F. Deemed Realization on Expatriate Exits

Deviation from traditional concepts of realization involves expatriates. Once again, the impetus behind such special treatment entails preventing tax avoidance, and in the case of expatriates, possible tax evasion. Under the U.S. tax system, U.S. citizens, resident aliens, and domestic corporations are generally subject to taxation on their worldwide income regardless of the source of their income. Nonresident aliens and foreign corporations, on the other hand, are only taxed on income "effectively connected" with a trade or business within the U.S. and on fixed, determinable, and periodic income (FDAP). The latter is imposed via a withholding tax at the source of thirty percent, unless reduced by treaty on such income items as dividends, interest, rents, and royalties. To alleviate the burden of double taxation (once in the U.S. and again in a foreign country), the U.S. permits a foreign income tax credit to offset foreign taxes paid or accrued on foreign source income subject to U.S. tax. Taxpayers have attempted to avoid the realization of income in the United States by giving up their U.S. citizenship and exiting the U.S. domestic tax system completely.

In the 1960s, the famed actress, Elizabeth Taylor, a dual citizen of both the United States and the United Kingdom, publicly spoke about relinquishing her American citizenship. (343) She had dual citizenship status because she was born in the United Kingdom of U.S. parents. (344) Upon relinquishment she therefore would have retained her U.K. citizenship. (345) The rationale behind her announced expatriation was not for the mundane and unromantic purpose of tax avoidance but the more noble and romantic one of love--her then-husband Sir Richard Burton. (346) To paraphrase a statement of hers, she didn't love America less but loved her husband more. (347) Being the unromantic entity that it is, the State Department refused to honor her request unless she renounced all allegiance to the United States. (348) She refused to do this, and the issue as it related to her was moot. However, it was discussed in the press for some time, and despite the higher purpose cited for her desire to expatriate, people, including some in Congress, thought it was for tax purposes.

The Foreign Investor's Tax Act of 1966 (FTA) (349) introduced an alternative tax regime, section 877, into the Code. (350) This provision was specifically designed to create an alternative tax system for those citizens and residents who sought to leave the United States for tax avoidance purposes. The statute, at least for a time, was referred to as the "Elizabeth Taylor Statute," a term hardly ever heard today even among seasoned tax professionals. Section 877 was amended in 1996 by the Health Insurance Portability and Accountability Act (HIPAA). (351) The deterrent behind the statute was that for the ten taxable years following the year in which a U.S. citizen relinquished his or her citizenship or a long-term resident terminated his or her residency, that former citizen or resident remained subject to U.S. taxation at the same rates applicable to U.S. citizens, but only on his or her U.S. source income. There were also income limits, net worth limits, and a modified definition of what constituted "U.S. source income."

The core of the statute was the requirement that expatriation be for the principal purpose of avoiding federal income tax. HIPAA added the rule that if the expatriate met several tax liability and net worth tests, he or she was presumed to have expatriated for tax avoidance. Expatriates could, however, overcome this presumption with facts and circumstances to the contrary by requesting a private letter ruling to that effect. Apparently, the Service was quite liberal in granting these rulings, thereby taking much of the sting out of the presumption. (352) In 2004, section 877 was amended again and expanded by the AJCA. (353) Four significant changes were made. The subjective motivation standard was eliminated, special rules were designed to determine the actual date of expatriation, the scope of U.S. taxation was expanded depending on continued significant contact with the United States, and finally, certain adjustments were made to the tax compliance aspects of the statute. Section 877 over the years raised substantial controversy over its effectiveness with many commentators criticizing it.

In response to this criticism and in reaction to the rising concerns about expatriation, the Heroes Earning Assistance and Relief Tax Act of 2008 (HEART) imposed even further barriers and rules for the would-be expatriate by enacting section 877A. (354) An excellent article by Professor Arsenault entitled appropriately, "Surviving a Heart Attack: Expatriation and the Tax Policy Implications of the New Exit Tax," provides a good summary of section 877A and discusses many of its tax-policy implications. (355) Section 877A creates a deemed realization event for the expatriate; this deemed realization event treats the expatriate as if he or she had sold all of his or her assets (beyond a certain threshold) on the day before expatriation. As a consequence, the realization and recognition of gain (or loss) is accelerated even though no actual sale or other disposition has taken place. Section 877A was clearly designed to affect only wealthy individuals attempting to avoid U.S. taxation. (356) Furthermore, the inherent gain subject to such deemed realization must be over $600,000 (adjusted for inflation). (357) Certain alternative elections also exist in the body of the statute. (358) This is a form of accretion taxation in its purest sense, and yet again, Congress felt compelled to deviate from constitutional realization. The motivation behind the enactment of section 877A was clearly one of preventing tax avoidance. The constitutionality of this statute was discussed at length in an article written by William Thomas Worster. (359) Worster's article raised such issues as substantive due process, explicit constitutional rights, and inherent rights that are by their nature deeply rooted in the country's history. (360) Realization as a constitutional necessity for income recognition, however, was not directly addressed. (361)

G. Section 1256 Contracts and Mark-to-Market Taxation

Section 1256 (362) contains another departure from the eroding principle of the realization of income (either upon cash receipt or in the case of an accrual based taxpayer, when the all events tests of section 451 (363) and the attendant regulations are satisfied). (364) Section 1256 was enacted as a result of the Economic Recovery Act of 1981. (365) The concern at the time was that taxpayers were using "tax straddle" schemes (often through the use of future contracts) to delay the payment of tax and thus avoid realization. (366)

A tax straddle transaction involves a taxpayer entering into an offsetting position by buying a futures contract for the delivery of a certain amount of a particular commodity. This transaction is referred to as the long position. The taxpayer would then sell a futures contract on the same commodity in the same amount. This is the so-called short position. The two contracts, taken as a whole, would not fluctuate in value, as they were both tied to the same fluctuation in market position. As a result, one contract would always be in a loss position, and one in a correlative gain position. The taxpayer would then close out the loss position at year-end, realizing and recognizing that loss. The taxpayer would continue, however, to hold the gain position, thus deferring realization until sometime in the future. To combat this taxpayer scheme, section 1256 addressed the timing play by instituting a mark-to-market system for certain derivatives. (367) Thus, a contact subject to section 1256 is taxed as if the taxpayer had sold the contract on the last day of the tax year--forcing realization and recognition of the contract's change in market value.

Initially, section 1256 only applied to a "regulated futures contract." A regulated futures contract is defined as a contract which requires that the amount to be deposited on which may be withdrawn is dependent on a system of marking-to-market and which is traded on a qualified board of exchange. A qualified board or exchange includes a national securities exchange registered with the SEC, a domestic board of trade classified as a contract market by the Commodity Futures Trading Commission, or any other exchange which the Secretary determines has rules adequate to be covered by the intent of the statute. (368) Later, section 1256 was expanded further to include "foreign currency contracts," basically, treating foreign currency as a commodity for the purposes of section 1256. (369) The character of mark-to-market gain (or loss) under section 1256 is split arbitrarily between sixty percent long-term capital gain (or loss) and forty percent short-term capital gain(or loss) regardless of how long the taxpayer may have actually held the contract at issue. (370)

H. Section 817A Modified Guaranteed Contracts

Mark-to-market taxation also infiltrated its way into the specialized area of taxation of life insurance companies. Subchapter L of the Code contains intricate and particularized provisions concerning the proper taxation of life insurance companies. (371) Under these provisions, a life insurance company engaged in variable contracts is required to account separately for the various items of income, exclusions, deductions, and other tax items attributable to such contracts (i.e., segregation under section 817(c)). (372)

A "modified guaranteed contract" generally refers to a class of annuity, life insurance, and pension that provides for a guaranteed interest rate for a specified period and a market value adjustment if the contract owner surrenders the contract (for cash) before the end of the guaranteed interest period. (373) Section 817A(d) defines a modified guaranteed contract as a contact not described in section 817 that satisfies the following:
  (1) All or part of the amounts received under the contract are
  allocated to an account which is segregated from the general asset
  account of the company and valued from time to time with
  reference to market values;
  (2) The contract provides for the payment of annuities, is a life
  insurance contract, or is a pension plan contract other than a life,
  accident and health, property casualty or liability contract; and
  (3) Reserves for the contract are valued at market for annual
  statement purposes and the contract provides for a section
  807(c)(1) defined net surrender value or a policy-holder fund. (374)

Although section 807(e)(1)(A)(ii) states that the net surrender value of a contract does not typically take into account market value adjustments on surrender, the rule does not apply to a modified guaranteed contract. (375) Section 817A(b)(1) provides that any gain or loss with respect to a segregated asset is to be treated as ordinary income or loss, and if any segregated asset is held at the close of the taxable year, the company must recognize gain or loss for the year as if the segregated asset had been sold for its fair market value on the last day of the year. (376) Section 817A(b)(1) provides yet another deemed realization event when no actual sale or other disposition has in fact occurred. (377) By adding section 817A to the Code Congress sought to obtain a more accurate measure of the income of life insurance companies by conforming the tax treatment of the modified guaranteed contracts to the annual statement of such contracts. (378) Furthermore, the Committee Report to section 817A in making reference to the regulatory authority granted to the Treasury states, in pertinent part, "It is intended that the regulations relating to asset transfers will forestall opportunities for selective recognition of ordinary items." (379) Once again, similar to the other mark-to-market rules discussed herein, tax avoidance was the congressional impetus behind the realization exception.

I. Deafen in Securities and Tax Avoidance

Unlike traders in securities, dealers in securities cannot elect deemed realization. Rather, a dealer in securities must under section 475(a)(1) compute taxable income by marking any securities held as inventory to market at the close of the taxable year. (380) As for any securities not held as inventory, a deemed realization event occurs under section 475(a)(2) under which, the security is deemed sold on the last business day of the taxable year for its fair market value. (381) Similar to a trader, proper adjustment must be made for any gain or loss subsequently realized on the actual sale or disposition of the security. (382) There are some exceptions to deemed realization for securities held for investment, certain notes, bonds, debentures, and other evidences of indebtedness acquired by the dealer in the ordinary course of business and not held for sale, and certain hedges which are not held in the dealer's capacity as a dealer. (383)

A dealer is distinguishable from an investor and a trader, in that a dealer is typically a broker in securities that regularly purchases and sells securities to customers in the ordinary course of business. (384) In other words, a dealer is like any other merchant purchasing inventory, and selling it to customers at a mark-up. (385) Typically, dealers are brokers that are registered with the Securities and Exchange Commission. Because these dealers are acquiring inventory, which is held out for sale to customers, any gain or loss attributable to their sale or disposition (or deemed disposition) is ordinary in character. (386) Furthermore, because a dealer is engaged in a trade or business all expenses incurred in the ordinary course are generally deductible under section 162. (387)

Under section 1236, a dealer is permitted capital gain treatment on certain securities held for investment, so long as the dealer properly identifies any such securities held for investment before the close of the day in which the security was acquired, and the security is not held primarily for sale to customers after such time or before. (388) Once such a security has been identified in the dealer's records as held for investment, the dealer cannot change its position if the security is subsequently sold at a loss, as section 1236(b) specifically denies ordinary loss treatment under such circumstances. (389)

Before section 475 was enacted, dealers in securities were required to maintain an inventory of securities held for sale to customers but could choose among the following methods of valuing that inventory:

(1).The cost of the securities (cost);

(2).The lower of the cost or market value (LOCOM); or

(3).The fair market value or the mark-to-market method (MTM). (390)

Congress, however, was concerned that the first two methods understated the dealer's actual income. (391) Under the LOCOM method, unrealized losses were deductible. By valuing inventory at a market price less than cost, year-end inventory was lower, cost of goods sold higher and taxable income lower. However, while this method resulted in the deductibility of unrealized losses, unrealized gains did not constitute income. While section 1256 subjected certain contracts to the MTM rules, these rules could often be avoided under the hedging exception then applicable to dealers. (392)

In addition, the cost method could be used to recognize unrealized losses and avoid the recognition of unrealized gains. Dealers would accomplish such by selling the loss securities and then repurchasing them at the same price. While the wash sale rules would normally prevent loss recognition on this type of transaction, section 1091 provided that the wash sale rules did not apply to dealers. (393) Interestingly, generally accepted accounting standards did, however, require mark-to-market accounting for dealers in securities. (394) Because of a dealer's ability to deduct unrealized losses, but avoid unrealized gains, Congress decided a mark-to-market system would more clearly reflect a securities dealer's income. (395) Congress also concluded that hedging contracts should be treated in the same fashion and imposed the mark-to-market rules here as well.

So again, the congressional departure from realization was believed to be tax avoidance by dealers in securities--specifically sales followed by reacquisition. Furthermore, the imposition of a mark-to-market system on securities dealers imposed little, if any, administrative burdens on the taxpayer as most (if not all) securities are publically traded and the rules of financial accounting require mark-to-market anyway.


As a consequence of Professor Surrey's premature demotion of realization, the academic community has left the constitutional aspects of the doctrine largely untouched over the years. Meanwhile the mark-to-market system has sprouted its roots in certain limited areas in tax law as an unavoidable evil necessary to prevent avoidance of the realization doctrine itself. Commentators over the years have referred to realization as everything from "the Achilles' heel" of the tax system to "the root of many tax evils." (396) A major critique of realization has been it distorts investment decisions, and induces tax motivated planning. (397) At times, it may be a simple case of the tail wagging the dog. There is also an incentive for taxpayers to avoid realization on their appreciated assets because of time value of money principals. By deferring taxes on unrealized economic gain, taxpayers are able to lower their effective tax rate as the investment horizon broadens. (398) This phenomenon, characterized as the lock-in effect, produces economic inefficiencies because a taxpayer's economic resources are not used towards their most productive purposes. (399) Whereas, a taxpayer that earns a living through wages does not have the option of deferral unless a deferred compensation plan is involved, and then some opportunities are available. (400) Built-in gain assets are also predominately held by upper-income taxpayers, thereby compounding the inequitable disparity among taxpayers. (401) By permitting nonrecognition in certain Code sections, taxpayers holding certain assets are also allowed to defer gain even longer beyond the natural cycle. And if an individual taxpayer holds onto an appreciated asset until death, he or she can escape the tax liability on unrealized gains entirely. (402) As far as unrealized losses are concerned, taxpayers suddenly embrace realization, and have an incentive to accelerate recognition, particularly during times of high marginal rates.

The exceptions to realization predominately occur in the Code. The courts, on the other hand, have never abandoned realization, but rather have reaffirmed its existence and tailored its application. (403) The current partial accretion taxation regime has even been encouraged by some academics, particularly with regard to marketable securities, which are easily valued and pose no liquidity issues. (404) What this article demonstrates, however, is although the doctrine of realization has been modified (or refined) from its early Macomber days it nevertheless has endured. It has also significantly influenced the Code, its regulations, and our entire income tax system. While the Supreme Court justices may have interpreted its outer contours in a series of cases, never once did they expressly abandon it. If anything, realization was expanded upon to curtail tax avoidance transactions.

Congress's reaction to realization has also been with reservation. Congress implicitly has codified the doctrine, and the Treasury has promulgated regulations concerning such. In a few limited circumstances, however, Congress enacted statutory exceptions thereto. A review of each exception, however, indicates Congress is only willing to ignore realization when: (1) taxpayers are exiting the taxing system completely, such as in the case of expatriates, or (2) when taxpayers are deferring unrealized gains beyond their natural life cycle by utilizing various tax avoidance strategies, such as certain offshore transactions. As far as elective realization is concerned, such events are almost only beneficial to taxpayers (not detrimental) and by their terms completely voluntary. Permitting accretion taxation for some taxpayers, while not others, is clearly inequitable.

In the end, perhaps the Supreme Court over the years reserved the thinly disguised threat of constitutional realization to prevent Congress (and the Treasury) from implementing an outright mark-to-market income tax system on the American taxpayer. Although Congress accepted the Court's dictum invitation, it has only done so carefully, by enacting piecemeal legislation around realization, predominately to prevent tax avoidance, and thereby not upset the delicate power balance. The authors suggest realization remain the bedrock triggering event before income recognition under the Code. Congress should also be careful not to encroach upon realization any further, except in those cases absolutely necessary to prevent tax avoidance, and not merely as a revenue raiser. The Supreme Court's administrative convenience invitation can always be withdrawn--when convenient.

(1.) I.R.C. [section] 1001.

(2.) The same holds true with respect to section 467 rental agreements and the requirement of accrual taxation, which is more of an issue of the frontloading (or back loading) of rental payments. than it is a deemed realization event on gain with respect to an asset.

(3.) There are exceptions to this general rule such as section 179 where taxpayers are permitted to expense a certain amount on qualified tangible personal property used in the taxpayer's trade or business. See I.R.C. [section] 179.

(4.) As discussed further in this article, many scholars believe that realization has its source founded upon administrative convenience rather than constitutional interpretation.

(5.) Robert M. Haig, The Concept of Income Economic and Legal Aspects, in THE FEDERAL INCOME TAX 1, 2 (Robert M. Haig ed., 1921).

(6.) Id. at 7.

(7.) Id.

(8.) Boris I. Bittker, A "Comprehensive Tax Base" as a Goal of Income Tax Reform, 80 HARV. L. REV. 925, 932 (1967).


(10.) Marjorie E. Kornhauser, The Story of Macomber: The Continuing Legacy of Realization, in TAX STORIES 93, 104 (Paul L. Caron ed., 2d ed. 2009) (Under the quantum theory capital was only viewed as a specific pecuniary amount and any increase in value beyond that amount was income.). Another good discussion of the basic concept of realization and its historical origins can be found in BNA Tax Management, U.S. Income Portfolios, 501-3rd, III., A (Gross Income: Basic Concepts).

(11.) Id.

(12.) Id.

(13.) Id.

(14.) I.R.C. [section] 61.

(15.) SIMONS supra note 9, at 207-08.

(16.) Boris, supra note 8, at 932 ("It is always admitted, to be sure, that valuation difficulties or administrative problems require some departures from the ideal (for example, with respect to unrealized appreciation, imputed income from assets, and domestic services by the taxpayer or his wife). ...").

(17.) It should also be noted that while realization is a necessary component of all taxable income inclusions, it is not by itself a sufficient one. As discussed further in this article, there must also be a recognition event. Nonrecognition events permitted by statute (or regulation) may encompass deferral (e.g., sections 351, 354, 361, etc. involving subchapter C transactions) or exclusions (e.g., section 121 dealing with gain on the disposition of a principal residence).

(18.) Kornhauser, supra note 10, at 96-98.

(19.) Eisner v. Macomber, 252 U.S. 189 (1920).

(20.) Id. at 190.

(21.) Towne v. Eisner, 245 U.S. 418, 426 (1918) (holding that a stock dividend takes nothing from the property of the corporation and adds nothing to the interests of its shareholders).

(22.) Id.

(23.) Id. at 424.

(24.) Macomber, 252 U.S. at 200.

(25.) Id. at 206.

(26.) Id.

(27.) Id.

(28.) Id.

(29.) Kornhauser, supra note 10, at 112-15. The Lochner era (1897-1937) was a period in which the Supreme Court tended to strike down regulations that sought to mandate working conditions or limit working hours. It was named after Lochner v. New York, in which the Court struck down a New York law that sought to limit the number of hours bakers could work. 198 U.S. 45,49 (1905).

(30.) Macomber, 252 U.S. at 213--15.

(31.) Id. at 217.

(32.) Id. at 206-07.

(33.) Calvin H. Johnson, Taxing the Consumption of Capital Gains, 28 VA. TAX REV. 477,478-81 (2009).

(34.) Id at 478.

(35.) Id at 488.

(36.) Kornhauser, supra note 10, at 117.

(37.) Macomber, 252 U.S. at 207.

(38.) Id.

(39.) Id.

(40.) Id. at 207 08.

(41.) Id

(42.) Id at 207 ("Brief as it is, it indicates the characteristic and distinguishing attribute of income essential for a correct solution of the present controversy. The government, although basing its argument upon the definition as quoted, placed chief emphasis upon the word 'gain,' which was extended to include a variety of meanings; while the significance of the next three words was either overlooked or misconceived. 'Derived--from--capital:' 'the gain--derived--from--capital,' etc. Here we have the essential matter: not a gain accruing to capital; not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and coining in, being 'derived'--that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal--that is income derived from property. Nothing else answers the description.").

(43.) Id. at 211.

(44.) Id. at 213.

(45.) Id. at 212 ("We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is the richer because of an increase of his capital, at the same time shows he has not realized or received a income in the transaction.").

(46.) Id. at 214-15 ("Conceding that the mere issue of a stock dividend makes the recipient no richer than before, the Government nevertheless contends that the new certificates measure the extent to which the gains accumulated by the corporation have made him the richer. There are two insuperable difficulties with this: In the first place, it would depend upon how long he had held the stock whether the stock dividend indicated the extent to which he had been enriched by the operations of the company; unless he had held it throughout such operations the measure would not hold true. Secondly, and more important for present purposes, enrichment through increase in value of capital investment is not income in any proper meaning of the term.").

(47.) Id. at 210.

(48.) See, e.g., Kornhauser, supra note 10, at 133.

(49.) Towne v. Eisner, 245 U.S. 418 (1918).

(50.) Macomber, 252 U.S. at 219-20 (Holmes, J., dissenting).

(51) Id.

(52.) Id.

(53.) Id.

(54.) Id . at 221 (Brandeis, J., dissenting).

(55.) Id. at 220 21.

(56.) Id. at 220-23.

(57.) Id.

(58.) Id. at 227.

(59.) Id. at 230.

(60.) Id.

(61.) Id.

(62.) Id.

(63.) Revenue Act of 1921, Pub. L. No. 67-98, 136 Stat. 227.

(64.) H.R. REP. No. 67-350, at 8 (1921); S. REP. No. 67-275, at 9 (1921).

(65.) I.R.C. [section] 305(a), (b).

(66.) Helvering v. Bruun, 309 U.S. 461, 469 (1940).

(67.) Id. at 461.

(68.) Id.

(69.) Id.

(70.) Id. at 464-65 ("The parties stipulated 'that as at said date, July 1, 1933, the building which had been erected upon said premises by the lessee had a fair market value of $64,245.68 and that the unamortized cost of the old building, which was removed from the premises in 1929 to make way for the new building, was $12,811.43, thus leaving a net fair market value as at July 1, 1933, of $51,434.25, for the aforesaid new building erected upon the premises by the lessee.' On the basis of these facts, the petitioner determined that in 1933 the respondent realized a net gain of $51,434.25. The Board overruled his determination and the Circuit Court of Appeals affirmed the Board's decision.").

(71.) Id. at 467 ("The respondent insists that the realty, a capital asset at the date of the execution of the lease, remained such throughout the term and after its expiration; that improvements affixed to the soil became part of the realty indistinguishably blended in the capital asset; that such improvements cannot be separately valued or treated as received in exchange for the improvements which were on the land at the date of the execution of the lease; that they are, therefore, in the same category as improvements added by the respondent to his land, or accruals of value due to extraneous and adventitious circumstances. Such added value, it is argued, can be considered capital gain only upon the owner's disposition of the asset. The position is that the economic gain consequent upon the enhanced value of the recaptured asset is not gain derived from capital or realized within the meaning of the Sixteenth Amendment and may not, therefore, be taxed without apportionment.").

(72.) Id.

(73.) Id. at 467.

(74.) Id at 468--69.

(75.) at 469.

(76.) Id ("Here, as a result of a business transaction, the respondent received back his land with a new building on it, which added an ascertainable amount to its value. It is not necessary to recognition of taxable gain that he should be able to sever the improvement begetting the gain from his original capital. If that were necessary, no income could arise from the exchange of property; whereas such gain has always been recognized as realized taxable gain.").

(77.) Id.

(78.) Id.

(79.) Id.

(80.) 1.R.C. [section] 109.

(81.) I.R.C. [section] 1019.

(82.) I.R.C. [section] 109.

(83.) I.R.C. [section] 1019.

(84.) Helvering v. Horst, 311 U.S. 112 (1940).

(85.) Id. at 114.

(86.) Id.

(87.) Id.

(88.) Id. at 115.

(89.)Id. at 115-116.

(90.) Id, at 116 ("But the rule that income is not taxable until realized has never been taken to mean that the taxpayer even on the cash receipts basis, who has fully enjoyed the benefit of the economic gain represented by his right to receive income, can escape taxation because he has not himself received payment of it from his obligor. The rule, founded on administrative convenience, is only one of postponement of the tax to the final event of enjoyment of the income, usually the receipt of it by the taxpayer, and not one of exemption from taxation where the enjoyment is consummated by some event other than the taxpayer's personal receipt of money or property.").

(91.) Id.

(92.) Id.

(93.) Id. at 120 ("It should be rejected here; for no more than in the Earl case can the purpose of the statute to tax the income to him who earns, or creates and enjoys it be escaped by 'anticipatory arrangements however skillfully devised' to prevent the income from vesting even for a second in the donor.").

(94.) Lucas v. Earl, 281 U.S. 111 (1930).

(95.) Horst. 31 1 U.S. at 117.

(96.) Id.

(97.) Id.

(98.) I.R.C. [section] 1015. As discussed later in this article section 102(a) excludes any gifts from a donee's gross income.

(99.) 1.R.C. [section] 1001(c).

(100.) I.R.C. [section] 1014.

(101.) Horst, 311 U .S. at 120.

(102.) President Is 1963 Tax Message: Hearings &yore the H.Comm. on Ways and Means, 88th Cong. 20 (1963).

(103.) Id. at 50.

(104.)Id at 49.

(105.) Id.

(106.) Id.

(107.) Id.

(108.) Id. at 47.

(109.) Eder v. Commissioner, 138 F.2d 27, 29 (2d Cir. 1943).


(111.) Tax savings can, however, be accomplished under section 170 by gifting certain appreciated long-term capital gain property to a charitable organization and thereby avoiding such built-in gain and receiving a full fair market value deduction (subject to certain limitations). I.R.C. [section] 170.

(112.) David J, Shakow, Taxation Without Realization: A Proposal for Accrual Taxation, 134 U. PA. L. REV. 1111 (1986) (proposing universal taxation on accretion basis); David Slawson, Taxing as Ordinary Income the Appreciation of Publicly Held Stock, 76 YALE L.J. 623 (1967) (proposing that holders of publically traded securities be taxed annually on unrealized gains and losses); Mark L. Louie, Note, Realizing Appreciation Without Sale: Accrual Taxation of Capital Gains on Marketable Securities, 34 STAN. L. REV. 857 (1982) (proposing mark-to-market taxation on publically traded stock).

(113.) See. e.g., Edward A. Zelinsky, For Realization: Income Taxation, Sectoral Accretionism, and the Virtue of Attainable Virtues, 19 CARDOZO L. REV. 861, 896 (1997).

(114.) Jeffrey L. Kwall, When Should Asset Appreciation Be Taxed?: The Case for Disposition Standard of Realization, 86 IND. L.J. 77, 79-88 (2011) ("Initially, the realization requirement was seen as a constitutional mandate ... The view that realization is constitutionally mandated has dissipated during the past three-quarters of a century ... Although Horst dealt with interest income rather than income in the form of asset appreciation, the Court retreated from the Macomber Court's view of realization as a general matter by finding that realization is based on administrative convenience. Moreover, the Court continues to adhere to this view.").

(115.) Stanley S. Surrey, The Supreme Court and the Federal Income Tax: Some Implications of the Recent Decisions, 35 ILL. L. REV. 779 (1941).

(116.) Henry Ordower, Revisiting Realization: Accretion Taxation, the Constitution, Macomber and Mark to Market, 13 VA. TAX REV. 1, 40 (1993).

(117.) See, e.g., MARVIN A. CHIRELSTEIN, FEDERAL INCOME TAXATION 73 (11th ed. 2009) ("[R]ealization is strictly an administrative rule and not a constitutional, much less an economic requirement, of 'income.'"); Boris I. Rinker, Charitable Gifts of Income and the Internal Revenue Code: Another View, 65 HARV. L. REV. 1375, 1380 (1952) ("Despite Eisner v. Macomber, 1 think all taxpayers could be put on an annual inventory basis with appreciation and depreciation being tallied up and taken into the tax return at year's end."); Erwin N. Griswold, Charitable Gifts of Income and the Internal Revenue Code, 65 HARV. L. REV. 84, 86 (1951) ("There was a time when our tax law was much concerned with problems of realization. It now would appear to some that perhaps this approach was unduly conceptualistic, and that the tax law has made progress in freeing itself somewhat from the rigidity of the older test"); Charles L.B. Lowndes, Current Conceptions of Taxable Income, 25 OHIO ST. L.J. 151, 176 (1964) ("Mt appears that as a constitutional prerequisite realization is no longer required. ..."); Patricia D. White, Realization, Recognition, Reconciliation, Rationality and the Structure of the Federal Income Tax System, 88 Wu. L. REV. 2034, 2046-47 (1990) ("Although Eisner v. Macomber has long since ceased to be important as a source of a definition of income or as constitutional interpretation, the sense that realization is intimately tied to the meaning of 'taxable income' has survived. Although some writers arc careful to refer to realization as an administrative rule intended to establish the time for taxation, others write of it, at least implicitly, as a requirement of taxability.").

(118.) Helvering v. Griffiths, 318 U.S. 371 (1943).

(119.) Id. at 371-72.

(120.) Id.

(121.) Id. at 372.

(122.) Id. at 394.

(123.) Id. at 373.

(124.) Id. at 389.

(125.) Id. at 375-94.

(126.) Id. at 394.

(127.) Koshland v. Helvering, 298 U.S. 441, 445-46 (1936) ("We are dealing solely with an income tax act. Under our decisions the payment of a dividend of new common shares, conferring no different rights or interests than did the old, the new certificates, plus the old, representing the same proportionate interest in the net assets of the corporation as did the old, does not constitute the receipt of income by the stockholder. On the other hand, where a stock dividend gives the stockholder an interest different from that which his former stock holdings represented he receives income. The latter type of dividend is taxable as income under the Sixteenth Amendment. Whether Congress has taxed it as of the time of its receipt, is immaterial for present purposes.").

(128.) Id. at 442 44.

(129.) Id. at 444.

(130.) Kornhauser, supra note 11, at 115-16.

(131.) Griffiths, 318 U.S. at 375.

(132.) Id. at 374.

(133.) Id. at 392-93.

(134.) Id. at 394.

(135.) Id.

(136.) Id. at 404 ("We are unable to find that Congress intended to tax the dividends in question, and without Congressional authority we are powerless to do so. That being the case, we cannot reach the reconsideration of [Eisner v. Macomber] on the basis of the present legislation and Regulations.").

(137.) Id. at 393-94.

(138.) Ordower, supra note 116, at 8-9 ("Commentators almost universally accept Professor Surrey's conclusions regarding the following: (1) there is no continuing vitality to Macomber's [sic] constitutional realization requirement, and (2) to the extent the tax law continues to include a realization requirement at all, it is solely a function of administrative convenience. Debate concerning a constitutionally-based realization requirement ended forty years ago. Yet, although the government has invited the Supreme Court to overrule its 1920 decision in Macomber, to date the Court has declined the invitation.").

(139.) I.R.C. [section] 1014.

(140.) Helvering v. Horst, 311 U.S. 112, 116 (1940) ("The rule, founded on administrative convenience, is only one of postponement of the tax to the final event of enjoyment of the income, usually the receipt of it by the taxpayer, and not one of exemption from taxation where the enjoyment is consummated by some event other than the taxpayer's personal receipt of money or property.").

(141.) See generally Ordower, supra note 116.

(142.) Phillip Mullock, The Constitutional Aspects of Realization, 31 U. Pin. L. REV. 615 (1970); Edward T. Roehner &Sheila M. Roehner, Realization: Administrative Convenience Or Constitutional Requirement?, 8 TAX L. REV. 173 (1953).

(143.) Ordower, supra note 116, at 29 30.

(144.) Id. at 86 ("Traditional tax jurisprudence provides no intelligible explanation of marking to market as a taxable event. Historical departures from fundamental tax principles sometimes find their justification in a need to defend the integrity of the taxing system from avoidance and abuse. For example, Congress has enacted statutes in the foreign tax realm that violate the realization requirement in order to combat specific tax abuses such as unlimited deferral. Although the Supreme Court has never passed upon the validity of those statutes, they have withstood the test of time.").

(145.) Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).

(146.) Id. at 431.

(147.) Id. at 427.

(148.) Id.

(149.) Revenue Act of 1916, ch. 463, 39 Stat. 756.

(150.) Glenshaw Glass Co., 348 U.S. at 430 31.

(151.) Id. at 431.

(152.) Id.

(153.) Id.

(154.) Id.

(155.) Id.

(156.) U.S. CONST. amend. XVI ("The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.").

(157.) Timothy Hurley, "Robbing" the Rich to Give to the Poor: Abolishing Realization and Adopting Mark-to-Market Taxation, 25 T.M. COOLEY L. REV. 529, 535 (2008).

(158.) Id. at 535 36.

(159.) Id.

(160.) Revenue Act of 1894, Pub. L. No. 227, 28 Stat. 509.

(161.) Hurley, supra note 157, at 536.

(162.) Pollock v. Farmers Loan & Trust Co., 157 U.S. 429, 583-84 (1895).

(163.) Id.

(164.) Marjorie E. Kornhauser, The Constitutional Meaning of Income and the Income Taxation of GO, 25 CONN. L. REV. 1, 11 12 (1992).

(165.) Id.

(166.) Id.

(167.) U.S. CONST. amend. XVI.

(168.) Revenue Act of 1913, Pub.L. No. 63-16, 38 Stat. 114, 166 ("[T]here shall be levied, assessed, collected, and paid annually upon the entire net income arising or accruing from all sources in the preceding calendar year to every citizen of the United States ... a tax of I per cent per annum upon such income.").

(169.) I.R.C. [section] 61(a)(3).

(170.) Treas. Reg. [section] 1.61-6(a) (1960) ("Gain realized on the sale or exchange of property is included in gross income, unless excluded by law. For this purpose property includes tangible items, such as a building, and intangible items, such as good will. Generally, the gain is the excess of the amount realized over the unrecovered cost or other basis for the property sold or exchanged. The specific rules for computing the amount of gain or loss are contained in section 1001 and the regulations thereunder.").

(171) I.R.C. [section] 1001.

(172.) Id.

(173.) Code section 451(a) and Treasury Regulation section 1.451 (1999) provide that for cash method taxpayers, gains, profits and income are to be included in the gross income in the year in which they are actually or constructively received by the taxpayer. Under the accrual method of accounting, however, income is includable in gross income when all the events have occurred that fix such event and the amount can be determined with reasonable accuracy. One arguably could construe the "all events test" and the actual or constructive receipts rule as a statutory mandate requiring realization. Not until one of those defined events occurs does realization occur. When it does, the amount is included in gross income. (174.) I.R.C. [section] 1001 (b) ("The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.").

(175.) Commissioner v. Tufts, 461 U.S. 300 (1983); Crane v. Commissioner, 331 U.S. 1 (1947).

(176.) I.R.C. [section] 1001(c) ("Except as otherwise provided in this subtitle, the entire amount of the gain or loss, determined under this section, on the sale or exchange of property shall be recognized.").

(177.) There are, however, some situations where realized losses go unrecognized such as loss transactions between related parties under section 267. See I.R.C. [section] 267.

(178.) Treas. Reg. [section] 1.1001-1(a) (2007) ("Except as otherwise provided in subtitle A of the Code, the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained. The amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of any property (other than money) received. The fair market value of property is a question of fact, but only in rare and extraordinary cases will property be considered to have no fair market value. The general method of computing such gain or loss is prescribed by section 1001(a) through (d) which contemplates that from the amount realized upon the sale or exchange there shall be withdrawn a sum sufficient to restore the adjusted basis prescribed by section 1011 and regulations thereunder (i.e., the cost or other basis adjusted for receipts, expenditures, losses, allowances, and other items chargeable against and applicable to such cost or other basis). The amount which remains after the adjusted basis has been restored to the taxpayer constitutes the realized gain. If the amount realized upon the sale or exchange is insufficient to restore to the taxpayer the adjusted basis of the property, a loss is sustained to the extent of the difference between such adjusted basis and the amount realized. The basis may be different depending upon whether gain or loss is being computed.").

(179.) Revenue Act of 1918 [section] 202(a), 40 Stat. 1057, 1060 (1919).

(180.) T.D. 2690 20 Treas. Dec. Int. Rev. 126, 186 (1918) ( Treas. Reg. 33, art. 116).

(181.) Revenue Act of 1924, ch. 234, [section] 202(a) 43 Stat. 253 ("Except as herein provided in this section, the gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the basis provided in subdivision (a) or (b) of subsection 204, and the loss shall be the excess of such basis over the amount realized.").

(182.) Treas. Reg. [section] 1.1001-1(a) (2007). It is also important to note that Treasury Regulation section 1.1002-1(d) (1960), concerning the now repealed Code section 1002 stated that ordinarily to constitute an "exchange" the transaction must be a reciprocal transfer of property, as distinguished from a transfer of property for money consideration only. (183.) Id.

(184.) Along this line of analysis, it is interesting to note Treasury Regulation 1.1001-3 (2011), which sets forth the parameters as to exactly when modifications to a debt instrument are material enough to constitute an exchange.

(185.) Cottage Say. Ass'n v. Commissioner, 499 U.S. 554, 559 (1991).

(186.) United States v. Centennial Say. Bank FSB, 499 U.S. 573, 578-79 (1991); Cottage Say. Ass 'n, 499 U.S. at 560-65.

(187.) Cottage Say. Ass'n, 499 U.S. at 561.

(188.) Cottage Say. Assn, 499 U.S. at 565; Centennial Say. Bank FSB, 499 U.S. at 578-79,

(189.) Loren D. Prescott, Jr., Cottage Savings Association v. Commissioner: Refining the Concept of Realization, 60 FORM-1AM L. REV. 437, 464 (1991) ("The Court's description of the legal entitlements test suggests that an exchange transaction will result in realized gain or loss unless the properties involved are 'the same.' This conclusion is buttressed by language later in the Court's opinion summarizing the new test: 'For, as long as the property entitlements are not identical, their exchange will allow both the commissioner and the transacting taxpayer easily to fix the appreciated or depreciated values of the property relative to their tax bases.'").

(190.) See also Treasury Regulation I.1001(c)(1) (2007), which provides for the realization of gain even though property is not sold or otherwise disposed of if amounts received to be applied to a property's basis exceed that basis. Code section 301(c)(3) provides an example of this where distributions from a corporation exceed both the earnings and profits of the corporation and the shareholder's basis in the stock upon which the distribution was made. Code sections 731(a)(1) and 357(c) also provide similar rules when cash is distributed to a partner in excess of the partner's outside basis or when debt is assumed by a corporation in excess of the basis of the property transferred by the stockholder. Nevertheless, whether section 301(c)(3), 731(a)(1) or 357(c) deems realization upon the taxpayer in each instance such is necessary to prevent tax avoidance.

(191.) Cottage Say. Ass 'n, 499 U.S. at 563-64.

(192.) Id. at 565.

(193.) Id. at 559.

(194.) Id. at 565.

(195.) Id. at 566.

(196.) Id. at 559.

(197.) Id. at 565.

(198.) San Antonio Say. Ass'n v. Commissioner, 887 F.2d 577, 582 (5th Cir. 1989); First Fed. Say. & Loan Ass'n of Temple v. United States, 694 F. Supp. 230, 239 (W.D. Tex. 1988) ("The confusion about realization in this case, as in many other cases, has been generated by the fact that the concept of realization has two distinct, component aspects which must both be satisfied before a gain or loss is 'realized' for tax purposes. First, there is the economic (or what can be called the 'common sense') aspect of realization. That is, 'Has there been an actual economic gain or loss?' This is generally put in terms of an economic increase or decrease in a taxpayer's net worth. This aspect has often been summed up by the famous paraphrase from Eisner V. Macomber, 'Is the taxpayer, in fact, richer or poorer?' Second, there is the practical accounting aspect of realization. Namely, that for accounting and valuation purposes the increase or decrease in a taxpayer's net worth (i.e. the value of his assets) will not be accounted for ('realized' as a practical matter) until there is some 'event that freezes or fixes the gain with sufficient certainty so that it is proper to tax it.' ... This second aspect of realization was developed to cope with the practical difficulties of annually computing and evaluating the fluctuations in the net worth of all of a taxpayer's assets which would not only be administratively quite difficult, speculative, and subject to unpredictability, but also could put taxpayers in the position of having to mortgage or sell property in order to pay the tax on its appreciation. This aspect also reflects the public's general distrust of 'paper' gains and losses, including their instability and the imprecision of calculating them."); Apt v. Birmingham, 89 F. Supp. 361, 376 (ND. Iowa 1950) ("The rule is founded upon administrative convenience, and operates to postpone the taxable event until realization is consummated by the assignee's receipt of the money (citing authority omitted). The reasoning underlying the rule, it is said, is the thought that the 'taxpayer procured the satisfaction of his wants' by diverting to others the income which he could have received himself, and that thereby he enjoyed the fruits of his labor or investment."); Dep't of Taxation v. Siegman, 24 Wis. 2d 92, 99 (Wis. 1964) ("As Horst suggests, the realization requirement is a matter of administrative convenience. The cost of conducting annual valuations of the appreciation on stock holdings, for example, would exceed the revenue recovered. The critical issue surrounding realization problems is not whether a receipt shall be taxed, but when it shall be taxed.").

(199.) See, e.g., Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 541 (1979).

(200.) See IRS Form 1120 (OMB No. 1545-0123) (2010), and its instructions.

(201.) See, e.g., Rev. Rul. 79-24, 1979-1 C.B. 60.

(202.) Kwall, supra note 114, at 89.

(203.) BLACK'S LAW DICTIONARY 489 (7th ed. 1999).

(204.) See discussion, supra Part I1(D), regarding legislation proposed in 1963 to tax inherent gains at the time of transfer as a result of the death of the transferor, and the 1969 proposals made by Treasury to the same effect.

(205.) BORIS I. BITTKER ET AL., FEDERAL INCOME TAXATION OF INDIVIDUALS [paragraph] 28.02 (3d ed. 2002).

(206.) Id.

(207.) I.R.C. [section] 1015(a).

(208.) I.R.C. [section] 102(a).

(209.) Lucas v. Earl, 281 U.S.111, 114-15 (1930) (taxpayer's assignment of compensation for services had preceded the rendition of services and was therefore income taxable to the donor and not the donee).

(210.) See, e.g., Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945) (sale imputed to corporation); Kinsey v. Commissioner, 477 F.2d 1058, 1063 (2d Cir. 1973) (gifts of stock taxable to the donor); Salvatore v. Commissioner, 434 F.2d 600, 601-02 (2d Cir.1970) (domes treated as mere conduits of donor).

(211.) Treas. Reg. [section] 1 .1001-2(a)(4)(iii) (1980) ("A disposition of property includes a gift of the property or a transfer of the property in satisfaction of liabilities to which it is subject."); Treas. Reg. 1.1001-2(c), Ex. 6 (1980) ("In 1977 D purchases an asset for $7,500. D pays the seller $1,500 in cash and signs a note payable to the seller for $6,000. D is not personally liable for repayment but pledges as security the newly purchased asset. In the event of default, the seller's only recourse is to the asset. During the years 1977 and 1978 D takes depreciation deductions on the asset totaling $4,200 thereby reducing D's basis in the asset to S3,300 ($7,500 -$4,200). In 1979 D transfers the asset to a trust which is not a "grantor trust" for purposes of subpart E of part 1 of subchapter J of the Code. Therefore D is not treated as the owner of the trust. The trust takes the asset subject to the liability and in addition pays D $750 in cash. Prior to the transfer D had reduced the amount outstanding on the liability to $4,700. D's amount realized on the transfer is $5,450 ($4,700 + $750). Since D's adjusted basis is $3,300, D's gain realized is $2,150 ($5,450 -$3,300).").

(212.) I.R.C. [section] 84(a).

(213.) 1.R.C. [section] 453B(a).

(214.) I.R.C. [section] 691(a)(2).

(215.) Commissioner v. Tufts, 461 U.S. 300, 307-09 (1983).

(216.) Crane v. Commissioner, 331 U.S. 1, 13-14 (1947).

(217.) See also the anti-stuffing rules of Code section 269, and Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945).

(218.) Code section 1031 provides nonrecognition of realized gain or loss for certain like kind exchanges of property held for productive use in a trade or business or for investment. Code section 1033 provides nonrecognition for certain involuntary conversions so long as a suitable replacement property is acquired. Code section 351 provides for nonrecognition of realized gain and loss under certain circumstances when property is transferred into a corporation in exchange for stock of the transferee corporation. Code section 721 sets forth the nonrecognition rule for realized gain and loss when property is transferred into a partnership in exchange for a partnership interest.

(219.) See, e.g., T.R.C. [section] 1031 (like kind exchanges), 1033 (involuntary conversions), 1041 (transfers incident to divorce), 721 (partnership formation), 351 (corporate formation).

(220.) Code section 7701(a)(45) defines a nonrecognition transaction as any "disposition" of property in a transaction in which gain or loss is deferred in whole or in part until a later point in time.

(221.) I.R.C. [section] 121.

(222.) I.R.C. [section] 475(t)(1)(A) (permitting traders in securities and commodities to elect deemed realization, specifying in pertinent part, "In the case of a person who is engaged in a trade or business as a trader in securities and who elects to have this paragraph apply to such trade or business--(i) such person shall recognize gain or loss on any security held in connection with such trade or business at the close of any taxable year as if such security were sold for its fair market value on the last business day of such taxable year, and (ii) any gain or loss shall be taken into account for such taxable year. Proper adjustment shall be made in the amount of any gain or loss subsequently realized for gain or loss taken into account under the preceding sentence. The Secretary may provide by regulations for the application of this subparagraph at times other than the times provided in this subparagraph"). With regard to dealers in commodities, section 475(e) permits them to make an election to be treated in a similar manner to dealers in securities.

(223) Id. [section] 475(f)(1)(A).

(224.) Id.

(225.) Id. [section] 475(f)(2).

(226.) Id. [section] 475(e)(1) ("In the case of a dealer in commodities who elects the application of this subsection, this section shall apply to commodities held by such dealer in the same manner as this section applies to securities held by a dealer in securities.").

(227.) Id.

(228.) Id. [section] 475(a) ("Notwithstanding any other provision of this subpart, the following rules shall apply to securities held by a dealer in securities: (1) any security which is inventory in the hands of the dealer shall be included in inventory at its fair market value. (2) in the case of any security which is not inventory in the hands of the dealer and which is held at the close of any taxable year--(A) the dealer shall recognize gain or loss as if such security were sold for its fair market value on the last business day of such taxable year, and (B) any gain or loss shall be taken into account for such taxable year. Proper adjustment shall be made in the amount of any gain or loss subsequently realized for gain or loss taken into account under the preceding sentence. The Secretary may provide by regulations for the application of this paragraph at times other than the times provided in this paragraph.").

(229.) Id. [section] 475(a)(2).

(230.) Paoli v. U.S., 954 F.2d 1429 (8th Cir. 1991) (the court determined the taxpayers had a substantial investment motivation in purchasing and/or carrying stock in their margin accounts and, because they held their stock for investment, they were investors and not in the trade or business of purchasing and selling securities); Hart v. Commissioner, 73 T.C.M. (CCH) 1684 (1997) (court determined the taxpayer's trading was not substantial because the taxpayer was not frequent, regular or continuous in his trading).

(231.) I.R.C. [section] 163(d)(1).

(232.) I.R.C. [section] 1222.

(233.) Section 1221 provides a list of items that are specifically excluded from the definition of a "capital asset," and because securities held by an investor taxpayer are not listed, they are therefore capital assets. I.R.C. 1221.

(234.) I.R.C. [section] 1001.

(235.) I.R.C. [section] 475(f).

(236.) Hart v. Commissioner, 73 T.C.M. (CCH) 1684 (1997).

(237.) Id.

(238.) In order for securities to be considered "inventory" and thus excluded from the definition of a capital asset under section 1221(a)(1), they must be "held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." I.R.C. [section] 1221(a)(1). Unfortunately for a trader in securities, this is not the case.

(239.) Under section 1222(1) and (2) short-term capital gains and losses occur when a taxpayer makes a sale or exchange of a capital asset held for not more than one year. I.R.C. [section] 1221(1), (2).

(240.) T.R.C. [section] 1222(5).

(241.) I.R.C. [section] 1211(b),1212(b).

(242.) If a taxpayer holds a capital asset for more than one year and makes a sale or exchange of the asset it is considered long-term capital gain or loss under the Code. Adjusted net capital gain is generally accorded preferential tax rates of zero or fifteen percent depending on the taxpayer's marginal bracket.

(243.) Section 475(f)(1)(D) provides that rules of subsection (d) apply if an election is made by a trader in securities. I.R.C. [section] 475(f)(1)(D). Section 475(d)(3)(A) states that any gain or loss is ordinary income or loss.

(244.) Id. [section] 475 (f)(2).

(245.) Id. [section] 172.

(246.) Shu-Yi Oei, A Structural Critique of Trader Taxation, 8 FLA. TAX REV. 1013, 1047 (2008).

(247.) I.R.C. [section] [section] 851,852.

(248.) I.R.C. [section] 551-558.

(249.) I.R.C. [section] 1291-1298.

(250.) Id.

(251.) See the Code section 1297(b)(1) reference to section 954(c) and the discussion of subpart F income, infra Part IV.D.

(252.) I.R.C.[section] 1297(c).

(253.) Id. [section] 1297(c)(2).

(254.) Id. [section] 1297(a)(2).

(255.) Id. [section] 1297(e)(2).

(256.) Id. [section] 1297(c).

(257.) I.R.C. [section] [section] 1293(a), 1295(a).

(258.) I.R.C.[section] 951(c).

(259.) I.R.C.[section] 1293(d).

(260.) 1.R.C. [section] [section] 902,1291(g)(2).

(261.) I.R.C. [section] 1291(a)(2).

(262.) Id. [section] 1291(b)(2).

(263.) Id. [section] 1291(c)(2) (3).

(264.) I.R.C. [section] 6621.

(265.) Craig M. Boise, Breaking Open Offshore Piggyhanks: Deferral and the Utility of Amnesty, 14 GEO. MASON L. REV. 667, 680 (2007).

(266.) Revenue Act of 1913, ch. 16, 38 Stat. 114, 166 ("[T]he taxable income of any individual shall embrace the share to which he would be entitled of the gains and profits, if divided or distributed, whether divided or distributed or not, of all corporations ... formed or fraudulently availed of for the purpose of preventing the imposition of such tax through the medium of permitting such gains and profits to accumulate instead of being divided or distributed.").

(267.) Id.

(268.) Homer L. Elliott, The Accumulated Earnings Tax and the Reasonable Needs of the Business: A Proposal, 12 WM. & MARY L. REV. 34, 35 (1970).

(269.) Id.

(270.) Id.

(271.) Id.

(272.) Revenue Act of 1913, ch. 16,38 Stat. 114, 167 ("... [and] the fact that any corporation ... is a mere holding company, or that the gains and profits are permitted to accumulate beyond the reasonable needs of the business[] shall be prima facie evidence of a [fraudulent] purpose to escape [such] tax ... in such case unless the [Secretary of the Treasury] [shall] certify[y] that in his opinion such accumulation is unreasonable for the purposes of the business.").

(273.) Id.

(274.) H.R. REP. No. 67-350, at 12--13(1921).

(275.) Revenue Act of 1921, ch. 136, [section] 220, 42 Stat. 247, 247-48.

(276.) Revenue Act of 1924, ch. 234, [section] 220, 43 Stat. 253, 277.

(277.) Revision of Revenue Laws 1938: Hearing Before the H. Comm. on Ways & Means, 75th Cong. 28-29 (1938) ("The provisions of section 102 of the Revenue Act of 1936 and corresponding provisions of prior revenue acts have proved very troublesome to enforce. The barrier to effective enforcement has been found to lie chiefly in the difficulty of proving the intent to avoid surtaxes. Little aid has been rendered such proof by the prima facie presumption of intent arising from the fact that the corporation is a mere holding company or has accumulated surplus beyond the reasonable needs of the business. A workable evidentiary test of unreasonable accumulations has not yet been found.").

(278.) National Grocery Co. v. Helvering, 92 F.2d 931, 935 (3d Cir. 1937), rev 'd 304 U.S. 282 (1938) (The Court of Appeals for the Third Circuit held that there was no evidence to support the findings of the Board of Tax Appeals which held that the taxpayer was liable for the tax. This decision, however, was later reversed by the Supreme Court); Cecil B. Demille v. Commissioner, 31 B.T.A. 1161, 1175 (1935) (holding that a taxpayer prevailed in its contention that the accumulated earnings were for the purpose of enabling it to engage in the production of motion pictures at some indefinite time in the future).

(279.) National Grocery Co., 92 F.2d at 931.

(280.) Id. at 935.

(281.) Revenue Act of 1936, ch. 690, [section] 14, 49 Stat. 1648, 1655-57.

(282.) Revenue Act of 1938, ch. 289, [section] 102(c), 52 Stat. 447, 483.

(283.) Stephen S. Ziegler, The "New" Accumulated Earnings Tax: A Survey of Recent Developments, 22 TAX L. REV. 77 (1966).

(284.) When determining the reasonably anticipated needs of a business, every portion of a corporation's "liquid assets" must be used in the operation of the business. In other words, the corporation must have a certain amount of "working capital" (i.e., excess current assets over current liabilities). To determine the amount of working capital required for a business, Service agents generally follow the Bardahl formula, which determines the entity's working capital requirements by ascertaining the amount needed for one full business cycle of the corporation.

(285.) H.R. REP. No. 73-704, at 11 (1934) (The reason for the change was that, "[b]y making partial distribution of profits and by showing some need for the accumulation of the remaining profits, the taxpayer makes it difficult to prove a purpose to avoid taxes.").

(286.) Id. at 11-12.

(287.) Revenue Act of 1934, ch. 277 [section][section] 102, 351, 48 Stat. 702, 702-03, 751 (1934).

(288.) Id. [section] 352.

(289.) I.R.C. [section] 542(a).

(290.) See, for example, Code section 543(a)(2) with respect to an exception for certain rents, Code section 543(a)(5) for certain produced film rents, and Code section 543(a)(4) for certain copyright royalties.

(291.) Repealed by the American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418, effective for tax years of foreign corporations beginning after December 31, 2004 and for tax years of United States shareholders with or within which such tax years of foreign corporations end.

(292.) I.R.C. [section] 565(a).

(293.) I.R.C. [section] 561(a)(2).

(294.) I.R.C. [section] 545(a).

(295.) I.R.C. [section] 535(a).

(296.) I.R.C. [section] 565(a).

(297.) Id. at (c).

(298.) Revenue Act of 1937, ch. 815, [section] 201, 50 Stat. 813, 818-24 (1937). The foreign personal holding company rules were codified in sections 551 thru 558 of the Code and were repealed for taxable years beginning after December 31, 2004. A foreign personal holding company was a foreign corporation that satisfied a stock ownership test held by U.S. citizens or residents and a certain percentage of its gross income was required to be "foreign personal holding company income."

(299.) Zelinsky, supra note 113, at 868.

(300.) Mint Eyal-Cohen, Prevention Tax Policy: Chief Justice Roger J. Traynor's Tax Philosophy, 59 HASTINGS L.J. 877, 884-86 (2008) ("Several incidents in the late 1930s involving senators and governmental officials exacerbated concerns about tax evasion. Roosevelt responded by campaigning for taxation of accumulated wealth; Congress instead adopted a slow and conservative approach. Revenue acts were enacted almost every year in an attempt to close new loopholes and halt the exploitation of tax laws by wealthy individuals and corporations, Reports published in 1937 described rich individuals sheltering money in foreign holding corporations, and incorporating their private yachts to escape taxation. In a bipartisan move, the government established a special Joint Committee on Tax Evasion and Avoidance. Within weeks, the Committee produced a report on common evasion techniques used by the sixty-seven wealthiest families in the United States. The report generated intense public reaction, and Congress responded by unanimously passing an act applying strict limitations on personal holding companies. It was clear at that time that compliance levels had declined, and the relationship between taxpayers and the government had deteriorated. As a result of those developments there was a shift in tax legislation: whereas previously officials had cited a need to raise revenue or a desire to make the tax system more progressive, the tax acts of the late 1930s marked the beginning of complex and frequent tax revisions enacted in response to tax evasion. As a result, taxpayers increasingly sought advice from tax lawyers, and the courts were faced with a high volume of tax disputes.") (footnotes omitted).

(301.) American Jobs Creation Act of 2004, Pub.L. No. 108-357, 118 Stat. 1418 (2004).

(302.) A foreign personal holding company was defined under the now repealed section 552(a) as any company (other than certain exempt companies) that satisfies a gross income requirement and a stock ownership requirement during the taxable year. I.R.C. [section] 552(a) (repealed 2004).

(303.) Id. [section] 552(a)(1).

(304.) Id. [section] 552(a)(2).

(305.) I.R.C. [section] 551-558 (repealed 2004).

(306.) Note this is comparable to the reason why rules with respect to corporate distributions and adjustments are referred to as Subchapter C, as they are, in fact, Subchapter C of the Code.

(307.) I.R.C. [section] 864(c)(4).

(308.) I.R.C. [section] 957(a).

(309.) A U.S. Person is defined by Code section 7701(a)(30), except for a few exceptions in Code section 957.

(310.) I.R.C. [section] 951(b).

(311.) I.R.C. [section] 958.

(312.) I.R.C. [section] 951(a)(2).

(313.) I.R.C. [section] 959.

(314.) I.R.C. [section] 961.

(315.) I.R.C. [section] 956.

(316.) I.R.C. [section] 952(a).

(317.) I.R.C. [section] 954(a).

(318.) Foreign base company shipping operations ceased to be a category of subpart F income for corporations with taxable years beginning after December 31, 2004 as a result of the AJCA. However, foreign base company shipping income (previously deferred by reinvestment) continues to be subject to recapture under section 955 when such income is no longer invested. I.R.C. [section] 955.

(319.) Id. [section] 955 (c).

(320.) I.R.C. [section] 553 (repealed 2004).

(321.) I.R.C. [section] 1297(b)(1).

(322.) See discussion supra Part III.E.

(323.) Garlock, Inc. v. Commissioner, 489 F.2d 197, 202 (2d Cir. 1973).

(324.) Eder, 138 F.2d at 28-29.

(325.) Id.; see also Alvord v. Commissioner, 277 F.2d 713 (4th Cir. 1960); Marsman v. Commissioner, 205 F.2d 335 (4th Cir. 1953).

(326.) Garlock, 489 F.2d at 203 n.5.

(327.) Heiner v. Mellon, 304 U.S. 271 (1938).

(328.) Garlock, 489 F.2d at 203 n.5.

(329.) Estate of Whitlock v. Commissioner, 494 F.2d 1297 (10th Cir. 1974).

(330.) Id. at 1297-98.

(331.) Id at 1301.

(332.) Id.

(333.) Id.

(334.) Helvering v. National Grocery Co., 304 U.S. 282, 289 (1938).

(335.) Id. ("It is said that section 104 is unconstitutional because the liability is laid upon the mere purpose to prevent imposition of the surtaxes, not upon the accomplishment of that purpose; and that, thus, it is a direct tax on the state of mind. But this is not so. The tax is laid 'upon the net income of such corporation.' The existence of the defined purpose is a condition precedent to the imposition of the tax liability, but this does not prevent it from being a true income tax within the meaning of the Sixteenth Amendment. The instances are many in which purpose or state of mind determines the incidence of an income tax.").

(336.) Id.

(337.) Id.

(338.) I.R.C. [section] 535.

(339.) I.R.C. [section] 531.

(340.) I.R.C. [section] 532(b).

(341.) I.R.C. [section] 565.

(342.) Id.

(343.) Kelly Phillips Erb, Are Taxpayers Moving to Avoid More Taxes?, TAXGIRL (July 19, 2010),

(344.) Id

(345.) Id

(346.) Id

(347.) Id

(348.) Id.

(349.) Foreign Investors Tax Act of 1966, Pub.L. No. 89-809, [section] 103(f), 80 Stat. 1539, 1551.

(350.) I.R.C. [section] 877.

(351.) Health Insurance Portability and Accountability Act of 1996, Pub. L. No. 104-191, [section] 511(a)-(d), (f)(1), 110 Stat. 2093, 2099.

(352.) Yu Hang Sunny Kwong, Catch Me if You Can: Relinquishing Citizenship for Tax Purposes After the 2008 Heart Act, 9 Hous. Bus. & TAX L.J. 411, 421 (2009).

(353.) American Jobs Creation Act of 2004, Pub. L. No. 108-357, [section] 804(a)(1), (2), (c), 118 Stat. 1569, 1570.

(354.) Heroes Earnings Assistance and Relief Tax Act of 2008, Pub. L. No. 110-245, [section] 301(a), 122 Stat. 1638 (2008).

(355.) Steven J. Arsenault, Surviving a Heart Attack: Expatriation and the Tax Policy Implications of the New Exit Tax, 24 AKRON TAX J. 37 (2009).

(356.) I.R.C. [section] 877A.

(357.) Id. [section] 877A(a)(3)(A).

(358.) Id. [section] 877A(b).

(359.) William Thomas Worster, The Constitutionality of the Taxation Consequences for Renouncing U.S. Citizenship, 9 FLA. TAX REV. 921 (2010).

(360.) Id. at 941-50.

(361.) Id.

(362.) I.R.C. [section] 1256.

(363.) I.R.C. [section] 451.

(364.) Treas. Reg. [section] 1.451-1(a) (1999) ("Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy.").

(365.) Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, [section] 503(a), 95 Stat. 172, 328 (1981).

(366.) Edward D. Kleinbard & Thomas L. Evans, The Role of Mark-to-Market Accounting in a Realization-Based Tax System; 75 TAXES 788, 801-08 (1997).

(367.) Note also the straddle rules of section 1092 which some commentators contend create a redundancy in this area.

(368.) I.R.C. [section] 1256(g)(7).

(369.) Technical Corrections Act of 1982, Pub.L. No. 97-448, [section] 105(c)(5)(B), 96 Stat. 2365,2386 (1982).

(370.) I.R,C. [section] 1256(a)(3).

(371.) I.R.C. [section] 801-818.

(372.) I.R.C. [section] 817(d) (defining a variable contract to include a life insurance contract, the amount of the death benefit or period of coverage being adjusted on the basis of the investment return and the market value of the segregated asset).

(373.) H.R. REP. No. 103-353, at 160 (1993).

(374.) I.R.C. [section] 817A(d).

(375.) I.R.C. [section] 817A(a).

(376.) Id. [section] 817A(b)(1).

(377.) Id.

(378.) See GORDON O. PEHRSON ET AL., TAX MANAGEMENT INC., PORTFOLIO 546, ANNUITIES, LIFE INSURANCE AND LONG TERM CARE PRODUCTS A-52 (2000). The result is to subject these contracts to the same treatment as those under section 475 discussed below.

(379.) H.R.REP. No. 104-737, at 314 (1996).

(380.) I.R.C. [section] 475(a)(1).

(381.) Id. [section] 475(a)(2).

(382.) Id.

(383.) Id. [section] 475(b) (providing that the rule does not apply to securities held for investment, certain notes, bonds, debentures or other evidences of indebtedness acquired by the taxpayer in the ordinary course of a trade or business and which is not held for sale and certain hedges); see also Treas. Reg. [section] 1.475(b)-1 (2002) (providing further information on the scope of the exemptions from mark-to-market treatment).

(384.) Section 475(c) defines a dealer in securities as "a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business; or regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business." I.R.C. [section] 475(c).

(385.) Because a dealer in securities holds inventory held primarily for sale to customers in the ordinary course of the dealer's trade or business any gain or loss is treated as ordinary gain or loss because the assets sold are excluded from the definition of a capital asset under section 1221(a)(1). See I.R.C. [section] 1221(a)(1).

(386.) Id.

(387.) I.R.C. [section] 162(a).

(388.) I.R.C. [section] 1236(a).

(389.) Id. [section] 1236(b).

(390.) Treas. Reg. [section] 1.471-5 (1993).

(391.) U.S. Tax. Rep. (Thomson Reuters/RIA) [paragraph] 4751.10.

(392.) I.R.C. [section] 1256(e).

(393.) I.R.C. [section] 1091(a).


(395.) Oei, supra note 246, at 1064.

(396.) David M. Schizer, Realization as Subsidy, 73 N.Y.U. L. REV. 1549, 1551 (1998).

(397.) Id. at 1551-52.

(398.) Deborah H. Schenk, A Positive Account of the Realization Rule, 57 TAX L. REV. 355, 384 (2004).

(399.) David Elkins, The Myth of Realization: Mark-to-Market Taxation of Publicly-Traded Securities, 10 FLA. TAX REV. 375, 384 (2010) ("Deferring tax on unrealized gain creates an incentive to retain appreciated property. A taxpayer holding such property might, therefore, continue to do so even though she would prefer-in the absence of tax considerations-to sell. In other words, the advantage of continued deferral might outweigh the advantage of moving into a different investment. This phenomenon--known as 'the lock-in effect'--impairs the flow of economic resources to their most productive uses, creating economic inefficiency and reducing societal welfare.").

(400.) Clarissa Potter, Mark-to-Market Taxation as the Way to Save the Income Tax--A Former Administrator's View, 33 VAL. U. L. REV. 879, 884-85 (1999).

(401.) Id.

(402.) I.R.C. [section] 1014 (providing that the basis in property received from the decedent is stepped-up (or down) to the fair market value of the asset on the date of the decedent's death (or the alternative valuation date, if elected)).

(403.) Ordower, supra note 116, at 58 ("Although undermined by commentary and the dicta of decisions like Cottage Savings Association v. Commissioner, realization as a constitutional principle, while perhaps lethargic, subsists. Its continuing vitality surrounds legislation which approaches or crosses the longstanding limits of realization with an aura of uncertainty.").

(404.) Elkins, supra note 399, at 383-85; Hurley, supra note 157, at 552-55; David A. Weisbach, A Partial Mark-to-Market Tax System, 53 TAX L. REV. 95,96-97 (1999);.

* Co-AUTHOR: Rodney P. Mock, J.D., LL.M, California Polytechnic State University, Associate Professor, Business Building (03), Office No. 03 - 424, Telephone No. (805) 756 -2730, Email:

** Co-AUTHOR: Jeffrey Tolin, J.D., LL.M., California Polytechnic State University, Associate Professor, Business Building (03), Office No. 03 - 423, Telephone No. (805) 756 - 5522, Email: jtolin@calpolvedu
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