Cottage Savings Association v. Commissioner
Encyclopedia
Cottage Savings Association v. Commissioner, , was an income tax
case before the Supreme Court of the United States
.
The Court was asked to determine whether the exchange of different participation interests
in home mortgage
s by a savings and loan association
was a "disposition of property" under Internal Revenue Code
(since this was the requirement for them to realize, and deduct, their losses on these mortgages).
The court determined that it was a "disposition of property" by making the following three holdings:
area. Like many other S&L's, Cottage Savings had a large number of long-term, low-interest
mortgages on its books, which declined in value as interest rates increased during the late 1970s.
These S&Ls could have achieved a tax savings from selling these mortgages at a loss, but they were dissuaded from doing so because the accounting regulation
s of the Federal Home Loan Bank Board
(FHLBB) would have required them to report these losses on their books, possibly putting them into insolvency
. Hoping to find another way for these S&Ls to realize their tax losses, the FHLBB promulgated a new regulation called "Memorandum R-49", under which the S&Ls would not have to show a loss on their books if they exchanged their mortgages for "substantially identical" mortgages held by other lenders.
Cottage Savings made a transaction pursuant to this regulation by exchanging 90% participation interests in 252 mortgages to four other S&Ls, receiving in return 90% participation interests in 305 mortgages. All the mortgages involved in the transaction were for homes in the Greater Cincinnati region. The fair market value
of the interests exchanged by each side was approximately $4.5 million. The face value
of the interests which Cottage Savings relinquished was approximately $6.9 million. On its 1980 federal income tax return
, Cottage Savings claimed a loss of $2,447,091, the adjusted difference between the face value of the participation interests it gave up and fair market value of the interests it received.
The Commissioner of Internal Revenue
disallowed Cottage Savings' deduction, so the S&L filed a petition for redetermination in the United States Tax Court
, which reversed the Commissioner's decision and permitted the deduction. The Commissioner appealed to the United States Court of Appeals for the Sixth Circuit
, which reversed the decision of the Tax Court, holding that even though Cottage Savings realized a loss in the transaction, it had not actually realized the loss during the 1980 tax year. The U.S. Supreme Court then granted certiorari
.
requires that the tax consequences of a gain or loss in property value be deferred until it is realized by "the sale or other disposition of property". Since the transaction was certainly not a sale, Justice Marshall
identified the main legal issue to be whether the exchange was a "disposition of property
."
Thus, to determine whether the exchange was a "disposition of property
," the court first had to determine whether §1001 incorporated a "material difference" requirement, and if so, what that requirement involved.
represents the Commissioner's interpretation of the Code, the Court deferred to the Commissioner's judgment, holding that the regulation was a reasonable interpretation of the Code and consonant with prior case law
.
Material difference defined. Marshall defined what constituted a "material difference" in property under §1001 by examination at what point "realization" had been found in past case law. He started with Eisner v. Macomber
, which dealt with exchange of stock
in corporation
s. In several cases after Eisner, the court held that an exchange of stock which occurred when a corporation reorganized in another state was a realization, because corporations have different rights and power in different states. Marshall reasoned that properties materially differ for tax purposes when their respective possessors enjoy different legal entitlements from each. As long as the properties being exchanged were not identical, a realization had taken place. This was a simpler, black letter rule
, as compared to what the Commissioner was arguing for, which would have examined not just the underlying substance of the transaction, but also the market and other non-tax regulations.
The properties exchanged were "materially different." Marshall held that the participation interests exchanged by Cottage Savings and the other S&Ls were "materially different" because the loans involved were made to different obligors and secured by different properties. Even though the interests were "substantially identical" for the FHLBB's purposes, that did not mean they were not materially different for taxation purposes. Therefore, the exchange was a "disposition of property," Cottage Savings had realized a loss, and their deduction was appropriate.
dissented, joined by Justice White
.
Income tax in the United States
In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...
case before the Supreme Court of the United States
Supreme Court of the United States
The Supreme Court of the United States is the highest court in the United States. It has ultimate appellate jurisdiction over all state and federal courts, and original jurisdiction over a small range of cases...
.
The Court was asked to determine whether the exchange of different participation interests
Participation (ownership)
In finance, "participation" is an ownership interest in a mortgage or other loan. In particular, loan participation is a cooperation of multiple lenders to issue a loan to one borrower...
in home mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s by a savings and loan association
Savings and loan association
A savings and loan association , also known as a thrift, is a financial institution that specializes in accepting savings deposits and making mortgage and other loans...
was a "disposition of property" under Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
(since this was the requirement for them to realize, and deduct, their losses on these mortgages).
The court determined that it was a "disposition of property" by making the following three holdings:
- Under § 1001(a), exchange of property gives rise to realization (a "disposition of property") only if the exchanged properties are "materially different."
- This concept of "material difference" is not defined by an economic substitute test (whether various parties would consider their differences to be "material"); rather, two properties are materially different if their respective possessors enjoy legal entitlements that are different in kind or extent.
- The S&L's 90% participation interest in its mortgages embodied legally distinct entitlements (and so was "materially different" from) the 90% mortgage participation interest it received from the other savings associations. Even if mortgages are "substantially identical" for purposes of Federal Home Loan Bank BoardFederal Home Loan Bank BoardThe Federal Home Loan Bank Board was a board created by the Federal Home Loan Bank Act of 1932 that created and oversaw the Federal Home Loan Banks also created by the act. It was superseded by the Federal Housing Finance Board and the Office of Thrift Supervision in the Financial Institutions...
"Memorandum R-49" on reporting losses, they can still exhibit "material difference" for the purposes of finding a "disposition of property."
Facts and procedural history
Cottage Savings Association was a savings & loan association (S&L) serving the Greater CincinnatiCincinnati/Northern Kentucky metropolitan area
The Cincinnati-Northern Kentucky metropolitan area is a metropolitan area that includes counties in the U.S. states of Ohio, Kentucky and Indiana, centered around the city of Cincinnati, Ohio. The United States Census defines the metropolitan area as the Cincinnati-Middletown Metropolitan...
area. Like many other S&L's, Cottage Savings had a large number of long-term, low-interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
mortgages on its books, which declined in value as interest rates increased during the late 1970s.
These S&Ls could have achieved a tax savings from selling these mortgages at a loss, but they were dissuaded from doing so because the accounting regulation
Regulation
Regulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...
s of the Federal Home Loan Bank Board
Federal Home Loan Bank Board
The Federal Home Loan Bank Board was a board created by the Federal Home Loan Bank Act of 1932 that created and oversaw the Federal Home Loan Banks also created by the act. It was superseded by the Federal Housing Finance Board and the Office of Thrift Supervision in the Financial Institutions...
(FHLBB) would have required them to report these losses on their books, possibly putting them into insolvency
Insolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
. Hoping to find another way for these S&Ls to realize their tax losses, the FHLBB promulgated a new regulation called "Memorandum R-49", under which the S&Ls would not have to show a loss on their books if they exchanged their mortgages for "substantially identical" mortgages held by other lenders.
Cottage Savings made a transaction pursuant to this regulation by exchanging 90% participation interests in 252 mortgages to four other S&Ls, receiving in return 90% participation interests in 305 mortgages. All the mortgages involved in the transaction were for homes in the Greater Cincinnati region. The fair market value
Fair market value
Fair market value is an estimate of the market value of a property, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market. An estimate of fair market value may be founded either on precedent or...
of the interests exchanged by each side was approximately $4.5 million. The face value
Face value
The Face value is the value of a coin, stamp or paper money, as printed on the coin, stamp or bill itself by the minting authority. While the face value usually refers to the true value of the coin, stamp or bill in question it can sometimes be largely symbolic, as is often the case with bullion...
of the interests which Cottage Savings relinquished was approximately $6.9 million. On its 1980 federal income tax return
Tax return (United States)
Tax returns in the United States are reports filed with the Internal Revenue Service or with the state or local tax collection agency containing information used to calculate income tax or other taxes...
, Cottage Savings claimed a loss of $2,447,091, the adjusted difference between the face value of the participation interests it gave up and fair market value of the interests it received.
The Commissioner of Internal Revenue
Commissioner of Internal Revenue
The Commissioner of Internal Revenue is the head of the Internal Revenue Service , a bureau within the United States Department of the Treasury.The office of Commissioner was created by Congress by the Revenue Act of 1862...
disallowed Cottage Savings' deduction, so the S&L filed a petition for redetermination in the United States Tax Court
United States Tax Court
The United States Tax Court is a federal trial court of record established by Congress under Article I of the U.S. Constitution, section 8 of which provides that the Congress has the power to "constitute Tribunals inferior to the supreme Court"...
, which reversed the Commissioner's decision and permitted the deduction. The Commissioner appealed to the United States Court of Appeals for the Sixth Circuit
United States Court of Appeals for the Sixth Circuit
The United States Court of Appeals for the Sixth Circuit is a federal court with appellate jurisdiction over the district courts in the following districts:* Eastern District of Kentucky* Western District of Kentucky...
, which reversed the decision of the Tax Court, holding that even though Cottage Savings realized a loss in the transaction, it had not actually realized the loss during the 1980 tax year. The U.S. Supreme Court then granted certiorari
Certiorari
Certiorari is a type of writ seeking judicial review, recognized in U.S., Roman, English, Philippine, and other law. Certiorari is the present passive infinitive of the Latin certiorare...
.
Issues
§1001(a) of the Internal Revenue CodeInternal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
requires that the tax consequences of a gain or loss in property value be deferred until it is realized by "the sale or other disposition of property". Since the transaction was certainly not a sale, Justice Marshall
Thurgood Marshall
Thurgood Marshall was an Associate Justice of the United States Supreme Court, serving from October 1967 until October 1991...
identified the main legal issue to be whether the exchange was a "disposition of property
Property
Property is any physical or intangible entity that is owned by a person or jointly by a group of people or a legal entity like a corporation...
."
- The Commissioner had argued that an exchange of properties can be a "disposition" only if the properties involved in the transaction are "materially different".
- Cottage Savings argued that "material difference" was not a requirement -- that any exchange of property could be considered a disposition. Just in case, it also argued that the participation interests exchange were materially different because they were securedSecurity interestA security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt. It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets...
by different real propertyReal propertyIn English Common Law, real property, real estate, realty, or immovable property is any subset of land that has been legally defined and the improvements to it made by human efforts: any buildings, machinery, wells, dams, ponds, mines, canals, roads, various property rights, and so forth...
.
Thus, to determine whether the exchange was a "disposition of property
Property
Property is any physical or intangible entity that is owned by a person or jointly by a group of people or a legal entity like a corporation...
," the court first had to determine whether §1001 incorporated a "material difference" requirement, and if so, what that requirement involved.
Majority Opinion
Material difference is a requirement for a disposition under §1001. Marshall cited Treasury Regulation §1.1001-1 , which required that an exchange of materially different properties constitutes a realization under the Tax Code. Congress delegated to the Commissioner the authority to make rules and regulations to enforce the Internal Revenue Code. Because Title 26 of the Code of Federal RegulationsCode of Federal Regulations
The Code of Federal Regulations is the codification of the general and permanent rules and regulations published in the Federal Register by the executive departments and agencies of the Federal Government of the United States.The CFR is published by the Office of the Federal Register, an agency...
represents the Commissioner's interpretation of the Code, the Court deferred to the Commissioner's judgment, holding that the regulation was a reasonable interpretation of the Code and consonant with prior case law
Case law
In law, case law is the set of reported judicial decisions of selected appellate courts and other courts of first instance which make new interpretations of the law and, therefore, can be cited as precedents in a process known as stare decisis...
.
Material difference defined. Marshall defined what constituted a "material difference" in property under §1001 by examination at what point "realization" had been found in past case law. He started with Eisner v. Macomber
Eisner v. Macomber
Eisner v. Macomber, , was a tax case before the United States Supreme Court. It is notable for the following holdings:*a pro rata stock dividend, where a shareholder received no actual cash or other property, and retained the same proportionate share of ownership of the corporation as was held...
, which dealt with exchange of stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
in corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
s. In several cases after Eisner, the court held that an exchange of stock which occurred when a corporation reorganized in another state was a realization, because corporations have different rights and power in different states. Marshall reasoned that properties materially differ for tax purposes when their respective possessors enjoy different legal entitlements from each. As long as the properties being exchanged were not identical, a realization had taken place. This was a simpler, black letter rule
Black letter law
The black letter law refers to the basic standard elements for a particular field of law, which are generally known and free from doubt or dispute...
, as compared to what the Commissioner was arguing for, which would have examined not just the underlying substance of the transaction, but also the market and other non-tax regulations.
The properties exchanged were "materially different." Marshall held that the participation interests exchanged by Cottage Savings and the other S&Ls were "materially different" because the loans involved were made to different obligors and secured by different properties. Even though the interests were "substantially identical" for the FHLBB's purposes, that did not mean they were not materially different for taxation purposes. Therefore, the exchange was a "disposition of property," Cottage Savings had realized a loss, and their deduction was appropriate.
Dissent
Justice BlackmunHarry Blackmun
Harold Andrew Blackmun was an Associate Justice of the Supreme Court of the United States from 1970 until 1994. He is best known as the author of Roe v. Wade.- Early years and professional career :...
dissented, joined by Justice White
Byron White
Byron Raymond "Whizzer" White won fame both as a football halfback and as an associate justice of the Supreme Court of the United States. Appointed to the court by President John F. Kennedy in 1962, he served until his retirement in 1993...
.
- First, Blackmun wanted to define "material difference" with reference to how the term "materiality" was defined. In TSC Industries, Inc. v. Northway, Inc.TSC Industries, Inc. v. Northway, Inc.TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 , was a case in which the Supreme Court of the United States articulated the requirement of materiality in securities fraud cases.-Facts and procedural history:...
, Justice Marshall himself had stated, in the context of securities fraud, that an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. By implication, a material difference is a difference capable of influencing the decision made by the parties to the transaction. - Second, Blackmun pointed out that the majority created something of an anomaly by allowing the property interests exchanged here to be "identical" for accounting purposes but "different" for tax purposes.
- Finally, he explained the he felt the substance of the transactions, including the fact that Cottage Savings retained a 10% interest in loans it traded away so it could continue servicing them, did not point to any real difference that should permit the allowance of a deduction.
Academic Commentary
The emphasis in Cottage Savings on realization as an administrative requirement makes evident the capricious role that realization plays in the tax field.- If the realization requirement can be met at a very low threshold, as the decision implies, then "realization" virtually becomes elective with the taxpayer.
- The hazard of elective or voluntary realization arises in connection with much investment activity.
- To prevent an investor from selling underwater assets to deduct realized losses from gross income without restriction, the Code permits the investor to offset so-called capital losses only against his realized capital gains. (Unused losses may be carried forward to subsequent years.) Investment losses are thus confined by the Code to a separate schedule, and so isolated from other kinds of taxable income.
See also
- List of United States Supreme Court cases, volume 499
- List of United States Supreme Court cases
- Lists of United States Supreme Court cases by volume
- List of United States Supreme Court cases by the Rehnquist Court