Burnet v. Logan
51 S. Ct. 550, 283 U.S. 404, 1931 U.S. LEXIS 896 (1931)
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Rule of Law:
When a taxpayer sells property for contingent future payments that have no ascertainable fair market value, the transaction is not considered closed. The taxpayer is entitled to recover their capital basis from the payments before any amount is recognized as taxable gain.
Facts:
- Mrs. Logan owned 250 shares in the Andrews & Hitchcock Iron Company.
- The company's primary asset was a 12% stock interest in the Mahoning Ore & Steel Company, which held a 97-year lease on an iron ore mine.
- The ore company was obligated to distribute extracted ore to its shareholders, including Andrews & Hitchcock, but the lease had no minimum or maximum production requirements, making annual output variable.
- On March 11, 1916, all Andrews & Hitchcock shareholders, including Logan, sold their shares to the Youngstown Sheet & Tube Company.
- The consideration for the sale was a lump sum of cash plus an agreement for Youngstown to pay the former shareholders 60 cents for each ton of ore it would receive from the mine in the future.
- The total amount of future payments was entirely dependent on the amount of ore mined, which was unpredictable.
- Logan also inherited a right to a portion of these future payments from her mother's estate, which was appraised for estate tax purposes.
- By 1920, the total payments Logan had received from both her original shares and her inheritance were less than her capital basis in each respective asset (the 1913 value of the shares and the appraised value of the inheritance).
Procedural Posture:
- The Commissioner of Internal Revenue determined that the contingent payment agreement had a fair market value on the date of the sale and treated the transaction as closed.
- Based on this valuation, the Commissioner made deficiency assessments against Mrs. Logan for the tax years 1918, 1919, and 1920, treating portions of her annual receipts as taxable income.
- Mrs. Logan appealed the Commissioner's assessments to the Board of Tax Appeals.
- The Board of Tax Appeals affirmed the Commissioner's determination.
- Mrs. Logan, as petitioner, appealed the Board's decision to the U.S. Circuit Court of Appeals.
- The Circuit Court of Appeals reversed the Board of Tax Appeals, holding that the agreement had no ascertainable market value and Logan was entitled to recover her capital before any income could be taxed.
- The Commissioner of Internal Revenue, Burnet, then petitioned the U.S. Supreme Court for a writ of certiorari, which was granted.
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Issue:
Is a taxpayer required to recognize taxable income from the sale of property for contingent future payments before the total payments received exceed the taxpayer's capital basis, when the fair market value of the contingent payments is not ascertainable?
Opinions:
Majority - Justice McReynolds
No. A taxpayer who sells property for contingent payments of an unascertainable value is not required to report gain until the capital basis is fully recovered. The promise of future payments was wholly contingent upon facts and circumstances not possible to foretell with anything like fair certainty. It had no ascertainable fair market value and was not the equivalent of cash. Therefore, the transaction was not a closed one. The court reasoned that a taxpayer is entitled to the return of their capital investment before being assessed for any taxable profit, citing the principle from Doyle v. Mitchell Bros. Co. that capital value must be restored before gain can be determined. To tax Logan based on a speculative valuation of the future payments would be to tax a gain based on conjecture, which may never actually be realized.
Analysis:
This landmark decision established the 'open transaction doctrine' in tax law, also known as the cost recovery method. It created a significant exception to the general rule that gain or loss on a sale is recognized in the year of the transaction. The doctrine applies in rare and extraordinary circumstances where the consideration received is so speculative that it has no ascertainable fair market value. This precedent profoundly impacts the structuring and taxation of transactions involving contingent payments, such as earn-outs in business sales or certain royalty agreements, allowing taxpayers to defer gain recognition until their investment is recouped.
