SCOTUS Reports

Tag: FIFO method

  • Kluger Associates, Inc. v. Commissioner, 69 T.C. 925 (1978): The Importance of Proper Stock Identification for Tax Purposes

    Kluger Associates, Inc. v. Commissioner, 69 T. C. 925 (1978)

    For tax purposes, the actual delivery of the stock certificates sold is essential to adequately identify the lot from which the stock was sold.

    Summary

    Kluger Associates and related entities sold securities from various lots at different times and prices, attempting to identify the specific lots sold through a ‘keying’ system in their ledger. However, they failed to deliver the corresponding certificates to the buyers, as required by IRS regulations. The Tax Court ruled that without delivering the identified certificates, the ‘keying’ system did not constitute adequate identification, necessitating the use of the FIFO method for determining the basis of the stocks sold. The court also upheld the reduction of net capital gains deductions by the taxes attributable to those gains for personal holding company tax calculations.

    Facts

    Kluger Associates, Inc. , Kluger, Inc. , and David Kluger engaged in the business of buying and selling securities. They maintained detailed subsidiary ledgers where purchases and sales were recorded, using a ‘keying’ system to match sales with specific lots of stock purchased at different times and prices. Despite this system, the actual certificates delivered to buyers did not always match those recorded as sold in the ledgers. The IRS audited their returns and found discrepancies between the ledger records and the certificates actually delivered and canceled by the issuing companies.

    Procedural History

    The IRS determined deficiencies in the petitioners’ federal income and personal holding company taxes, asserting that the petitioners failed to adequately identify the stock sold, requiring the use of the FIFO method to calculate stock basis. The Tax Court consolidated the cases of Kluger Associates, Inc. , Kluger, Inc. , and David Kluger, and ultimately ruled in favor of the IRS on the identification issue and the calculation of personal holding company taxes.

    Issue(s)

    1. Whether the petitioners’ system of record keeping satisfied the requirement of adequate identification set forth in section 1. 1012-1(c) of the Income Tax Regulations.
    2. If not, (a) whether the IRS correctly employed the FIFO method in computing the basis of the securities sold by petitioners; and (b) whether the IRS properly reduced the net long-term capital gain deductions of the corporate petitioners by the income tax attributable to contested capital gains in computing undistributed personal holding company income under section 545(b)(5).

    Holding

    1. No, because the petitioners did not deliver the specific certificates identified in their records as sold.
    2. (a) Yes, because the IRS’s use of the FIFO method was reasonable given the failure to adequately identify the stocks sold; (b) Yes, because reducing the net capital gains deduction by the taxes attributable to those gains prevents a double deduction and is in line with statutory intent.

    Court’s Reasoning

    The court emphasized that under section 1. 1012-1(c)(2) of the Income Tax Regulations, adequate identification requires the delivery of the specific certificates recorded as sold. The petitioners’ ‘keying’ system did not meet this requirement as they frequently delivered certificates different from those identified in their records. The court found the IRS’s use of the FIFO method to be reasonable and upheld the adjustments to the personal holding company tax calculations, citing the need to prevent a double deduction of taxes on capital gains as per section 545(b)(5). The decision was based on the principle established in Davidson v. Commissioner, where delivery, not intention, determines the identity of shares sold. The court also noted that the petitioners’ system, despite being used for years, did not comply with the regulations.

    Practical Implications

    This decision underscores the importance of ensuring that the actual certificates delivered to buyers match those identified in the seller’s records for tax purposes. Taxpayers must maintain rigorous record-keeping and delivery systems to avoid the default application of the FIFO method, which can result in higher tax liabilities. For practitioners, this case highlights the need to advise clients on the strict requirements of stock identification and the potential tax implications of non-compliance. Businesses dealing in securities should review their record-keeping and delivery practices to align with IRS regulations. Subsequent cases have continued to apply this principle, reinforcing the need for strict adherence to identification rules in stock sales.

  • Malkan v. Comm’r, 54 T.C. 1305 (1970): Substance Over Form in Determining Taxpayer of Stock Sale Gains

    Malkan v. Commissioner, 54 T. C. 1305 (1970)

    A sale of stock cannot be attributed to a trust for tax purposes if the taxpayer, rather than the trust, negotiated and controlled the sale.

    Summary

    Arnold Malkan attempted to attribute the sale of 10,500 shares of General Transistor Corp. stock to four family trusts he established, arguing he had transferred the shares to the trusts before the sale. However, the U. S. Tax Court determined that Malkan himself sold the shares, as he negotiated the sale terms before creating the trusts and actively participated in the sale’s closing. The court applied the substance-over-form doctrine, holding that the trusts were mere conduits for the sale. Additionally, the court ruled that the basis for the sold shares should be calculated using the first-in, first-out (FIFO) method, starting from the shares Malkan placed in escrow before the public offering.

    Facts

    Arnold Malkan, an attorney and shareholder in General Transistor Corp. (GTC), decided to sell his GTC stock due to disagreements with management. Before the sale, he discussed creating trusts for his family. On June 26, 1958, Malkan agreed to sell 73,888 shares through a public offering and placed 16,000 shares in escrow. On July 15, he prepared trust instruments, but they were not executed until July 18. Negotiations continued, and by July 21, the terms of the sale were finalized. The trusts were reexecuted on July 21 to clarify their New Jersey situs. On July 22, Malkan signed the underwriting agreement as both an individual and trustee. The sale closed on July 29, with Malkan reporting the gain from the sale on his personal tax return.

    Procedural History

    The Commissioner of Internal Revenue determined a deficiency in Malkan’s 1958 tax return, asserting that Malkan, not the trusts, sold the 10,500 shares and that the basis should be calculated using the FIFO method. Malkan petitioned the U. S. Tax Court, which heard the case and issued its opinion on June 17, 1970.

    Issue(s)

    1. Whether the sale of 10,500 shares of GTC stock was made by Arnold Malkan or by the four trusts he created as settlor-trustee.
    2. What was the proper basis for the shares sold by Malkan?

    Holding

    1. No, because the sale was negotiated and controlled by Malkan personally before the trusts were created, and he actively participated in the closing as an individual.
    2. The basis should be calculated using the FIFO method, starting from the 16,000 shares placed in escrow on July 14, 1958, because they were the first transferred shares.

    Court’s Reasoning

    The court applied the substance-over-form doctrine, emphasizing that the sale’s reality, not its formalities, determines tax consequences. Malkan negotiated the sale terms before creating the trusts and signed the underwriting agreement both personally and as trustee. The trusts were merely conduits for the sale, as Malkan intended them to hold the sale proceeds, not the shares themselves. The court cited Commissioner v. Court Holding Co. to support its decision, rejecting Malkan’s reliance on cases where trusts were found to have made sales independently. For the basis calculation, the court ruled that the 16,000 shares placed in escrow constituted a transfer under the FIFO rule, as Malkan relinquished control over them before the closing.

    Practical Implications

    This case underscores the importance of substance over form in tax law, particularly in transactions involving trusts. Taxpayers cannot use trusts to shift tax liability if they control the underlying transaction. Practitioners should advise clients to carefully structure transactions to avoid the appearance of using trusts as mere conduits. The FIFO method’s application to determine basis serves as a reminder to identify shares sold to avoid unfavorable tax consequences. Subsequent cases have cited Malkan in similar contexts, reinforcing its principle that the taxpayer who negotiates and controls a sale cannot shift the tax consequences to a trust.