These consolidated cases present the question of the applicability of the tax benefit rule to two corporate tax situations: the repayment to the shareholders of taxes for which they were liable but that were originally paid by the corporation; and the distribution of expensed assets in a corporate liquidation. We conclude that, unless a nonrecognition provision of the Internal Revenue Code prevents it, the tax benefit rule ordinarily applies to require the inclusion of income when events occur that are fundamentally inconsistent with an earlier deduction. Our examination of the provisions granting the deductions and governing the liquidation in these cases lead us to hold that the rule requires the recognition of income in the case of the liquidation but not in the case of the tax refund.

* In No. 81-485, Hillsboro National Bank v. Commissioner, the petitioner, Hillsboro National Bank, is an incorporated bank doing business in Illinois. Until 1970, Illinois imposed a property tax on shares held in incorporated banks. Ill.Rev.Stat., ch. 120, § 557 (1971). Banks, required to retain earnings sufficient to cover the taxes, § 558, customarily paid the taxes for the shareholders. Under § 164(e) of the Internal Revenue Code of 1954, 26 U.S.C. § 164(e),1 the bank was allowed a deduction for the amount of the tax, but the shareholders were not. In 1970, Illinois amended its constitution to prohibit ad valorem taxation of personal property owned by individuals, and the amendment was challenged as a violation of the Equal Protection Clause of the Federal Constitution. The Illinois courts held the amendment unconstitutional in Lake Shore Auto Parts Co. v. Korzen, 49 Ill.2d 137, 273 N.E.2d 592 (1971). We granted certiorari, 405 U.S. 1039, 92 S.Ct. 1307, 31 L.Ed.2d 579 (1972), and, pending disposition of the case here, Illinois enacted a statute providing for the collection of the disputed taxes and the placement of the receipts in escrow. Ill.Rev.Stat. ch. 120, § 676.01 (1979). Hillsboro paid the taxes for its shareholders in 1972, taking the deduction permitted by § 164(e), and the authorities placed the receipts in escrow. This Court upheld the state constitutional amendment in Lehnhausen v. Lake Shore Auto Parts Co., 410 U.S. 356, 93 S.Ct. 1001, 35 L.Ed.2d 351 (1973). Accordingly, in 1973 the County Treasurer refunded the amounts in escrow that were attributable to shares held by individuals, along with accrued interest. The Illinois courts held that the refunds belonged to the shareholders rather than to the banks. See Bank & Trust Company of Arlington Heights v. Cullerton, 25 Ill.App.3d 721, 726, 324 N.E.2d 29 (1975) (alternative holding); Lincoln National Bank v. Cullerton, 18 Ill.App.3d 953, 310 N.E.2d 845 (1974). Without consulting Hillsboro, the Treasurer refunded the amounts directly to the individual shareholders. On its return for 1973, Hillsboro recognized no income from this sequence of events.2 The Commissioner assessed a deficiency against Hillsboro, requiring it to include as income the amount paid its shareholders from the escrow. Hillsboro sought a redetermination in the Tax Court, which held that the refund of the taxes, but not the payment of accrued interest, was includible in Hillsboro's income. On appeal, relying on its earlier decision in First Trust and Savings Bank v. United States, 614 F.2d 1142 (CA7 1980), the Court of Appeals for the Seventh Circuit affirmed. 641 F.2d 529, 531 (CA7 1981).

In No. 81-930, United States v. Bliss Dairy, Inc., the respondent, Bliss Dairy, Inc., was a closely held corporation engaged in the business of operating a dairy. As a cash basis taxpayer, in the taxable year ending June 30, 1973, it deducted upon purchase the full cost of the cattle feed purchased for use in its operations, as permitted by § 162 of the Internal Revenue Code, 26 U.S.C. § 162.3 A substantial portion of the feed was still on hand at the end of the taxable year. On July 2, 1973, two days into the next taxable year, Bliss adopted a plan of liquidation, and, during the month of July, it distributed its assets, including the remaining cattle feed, to the shareholders. Relying on § 336, which shields the corporation from the recognition of gain on the distribution of property to its shareholders on liquidation,4 Bliss reported no income on the transaction. The shareholders continued to operate the dairy business in noncorporate form. They filed an election under § 333 to limit the gain recognized by them on the liquidation,5 and they therefore calculated their basis in the assets received in the distribution as provided in § 334(c).6 Under that provision, their basis in the assets was their basis in their stock in the liquidated corporation, decreased by the amount of money received, and increased by the amount of gain recognized on the transaction. They then allocated that total basis over the assets, as provided in the regulations, Treas.Reg. § 1.334-2, 26 CFR § 1.334-2 (1982), presumably taking a basis greater than zero in the feed, although the amount of the shareholders' basis is not in the record. They in turn deducted their basis in the feed as an expense of doing business under § 162. On audit, the Commissioner challenged the corporation's treatment of the transaction, asserting that Bliss should have taken into income the value of the grain distributed to the shareholders. He therefore increased Bliss's income by $60,000. Bliss paid the resulting assessment and sued for a refund in the district court for the District of Arizona, where it was stipulated that the grain had a value of $56,565, see Pretrial Order at 3. Relying on Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (CA9 1963), the district court rendered a judgment in favor of Bliss. While recognizing authority to the contrary, Tennessee-Carolina Transportation, Inc. v. Commissioner, 582 F.2d 378 (CA6 1978), cert. denied, 440 U.S. 909, 99 S.Ct. 1219, 59 L.Ed.2d 457 (1979), the Court of Appeals saw South Lake Farms as controlling and affirmed. 645 F.2d 19 (CA9 1981) (per curiam ).

The Government7 in each case relies solely on the tax benefit rule—a judicially developed principle8 that allays some of the inflexibilities of the annual accounting system. An annual accounting system is a practical necessity if the federal income tax is to produce revenue ascertainable and payable at regular intervals. Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365, 51 S.Ct. 150, 152, 75 L.Ed. 383 (1931). Nevertheless, strict adherence to an annual accounting system would create transactional inequities. Often an apparently completed transaction will reopen unexpectedly in a subsequent tax year, rendering the initial reporting improper. For instance, if a taxpayer held a note that became apparently uncollectable early in the taxable year, but the debtor made an unexpected financial recovery before the close of the year and paid the debt, the transaction would have no tax consequences for the taxpayer, for the repayment of the principal would be recovery of capital. If, however, the debtor's financial recovery and the resulting repayment took place after the close of the taxable year, the taxpayer would have a deduction for the apparently bad debt in the first year under § 166(a) of the Code, 26 U.S.C. § 166(a). Without the tax benefit rule, the repayment in the second year, representing a return of capital, would not be taxable. The second transaction, then, although economically identical to the first, could, because of the differences in accounting, yield drastically different tax consequences. The Government, by allowing a deduction that it could not have known to be improper at the time, would be foreclosed9 from recouping any of the tax saved because of the improper deduction.10 Recognizing and seeking to avoid the possible distortions of income,11 the courts have long required the taxpayer to recognize the repayment in the second year as income. See, e.g., Estate of Block v. Commissioner, 39 B.T.A. 338 (1939), aff'd sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (CA7), cert. denied, 311 U.S. 658, 61 S.Ct. 12, 85 L.Ed. 421 (1940); South Dakota Concrete Products Co. v. Commissioner, 26 B.T.A. 1429 (1932); Plumb, The Tax Benefit Rule Today, 57 Harv.L.Rev., 129, 176, 178 and n. 172 (1943) (hereinafter Plumb).12

The taxpayers and the Government in these cases propose different formulations of the tax benefit rule. The taxpayers contend that the rule requires the inclusion of amounts recovered in later years, and they do not view the events in these cases as "recoveries." The Government, on the other hand, urges that the tax benefit rule requires the inclusion of amounts previously deducted if later events are inconsistent with the deductions; it insists that no "recovery" is necessary to the application of the rule. Further, it asserts that the events in these cases are inconsistent with the deductions taken by the taxpayers. We are not in complete agreement with either view.

An examination of the purpose and accepted applications of the tax benefit rule reveals that a "recovery" will not always be necessary to invoke the tax benefit rule. The purpose of the rule is not simply to tax "recoveries." On the contrary, it is to approximate the results produced by a tax system based on transactional rather than annual accounting. See generally Bittker and Kanner, The Tax Benefit Rule, 26 U.C.L.A.L.Rev. 265, 270 (1978); Byrne, The Tax Benefit Rule as Applied to Corporate Liquidations and Contributions to Capital: Recent Developments, 56 Notre Dame Law. 215, 221, 232 (1980); Tye, The Tax Benefit Doctrine Reexamined, 3 Tax L.Rev. 329 (1948) (hereinafter Tye). It has long been accepted that a taxpayer using accrual accounting who accrues and deducts an expense in a tax year before it becomes payable and who for some reason eventually does not have to pay the liability must then take into income the amount of the expense earlier deducted. See, e.g., Mayfair Minerals, Inc. v. Commissioner, 456 F.2d 622 (CA5 1972) (per curiam ); Bear Manufacturing Co. v. United States, 430 F.2d 152 (CA7 1970), cert. denied, 400 U.S. 1021, 91 S.Ct. 583, 27 L.Ed.2d 632 (1971); Haynsworth v. Commissioner, 68 T.C. 703 (1977), aff'd without op., 609 F.2d 1007 (CA5 1979); G.M. Standifer Construction Corp. v. Commissioner, 30 B.T.A. 184, 186-187 (1934), petition for review dism'd, 78 F.2d 285 (CA9 1935). The bookkeeping entry cancelling the liability, though it increases the balance sheet net worth of the taxpayer, does not fit within any ordinary definition of "recovery."13 Thus, the taxpayers' formulation of the rule neither serves the purposes of the rule nor accurately reflects the cases that establish the rule. Further, the taxpayers' proposal would introduce an undesirable formalism into the application of the tax benefit rule. Lower courts have been able to stretch the definition of "recovery" to include a great variety of events. For instance, in cases of corporate liquidations, courts have viewed the corporation's receipt of its own stock as a "recovery," reasoning that, even though the instant that the corporation receives the stock it becomes worthless, the stock has value as it is turned over to the corporation, and that ephemeral value represents a recovery for the corporation. See, e.g., Tennessee-Carolina Transportation, Inc. v. Commissioner, 582 F.2d 378, 382 (CA6 1978), cert. denied, 440 U.S. 909, 99 S.Ct. 1219, 59 L.Ed.2d 457 (1979) (alternative holding). Or, payment to another party may be imputed to the taxpayer, giving rise to a recovery. See First Trust and Savings Bank v. United States, 614 F.2d 1142, 1146 (CA7 1980) (alternative holding). Imposition of a requirement that there be a recovery would, in many cases, simply require the Government to cast its argument in different and unnatural terminology, without adding anything to the analysis.14

The basic purpose of the tax benefit rule is to achieve rough transactional parity in tax, see note 12, supra, and to protect the Government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been erroneous. Such an event, unforeseen at the time of an earlier deduction, may in many cases require the application of the tax benefit rule. We do not, however, agree that this consequence invariably follows. Not every unforeseen event will require the taxpayer to report income in the amount of his earlier deduction. On the contrary, the tax benefit rule will "cancel out" an earlier deduction only when a careful examination shows that the later event is indeed fundamentally inconsistent with the premise on which the deduction was initially based.15 That is, if that event had occurred within the same taxable year, it would have foreclosed the deduction.16 In some cases, a subsequent recovery by the taxpayer will be the only event that would be fundamentally inconsistent with the provision granting the deduction. In such a case, only actual recovery by the taxpayer would justify application of the tax benefit rule. For example, if a calendar-year taxpayer made a rental payment on December 15 for a 30-day lease deductible in the current year under § 162(a)(3), see Treas.Reg. § 1.461-1(a)(1), 26 CFR § 1.461-1(a)(1) (1982); e.g., Zaninovich v. Commissioner, 616 F.2d 429 (CA9 1980),17 the tax benefit rule would not require the recognition of income if the leased premises were destroyed by fire on January 10. The resulting inability of the taxpayer to occupy the building would be an event not fundamentally inconsistent with his prior deduction as an ordinary and necessary business expense under § 162(a). The loss is attributable to the business18 and therefore is consistent with the deduction of the rental payment as an ordinary and necessary business expense. On the other hand, had the premises not burned and, in January, the taxpayer decided to use them to house his family rather than to continue the operation of his business, he would have converted the leasehold to personal use. This would be an event fundamentally inconsistent with the business use on which the deduction was based.19 In the case of the fire, only if the lessor—by virtue of some provision in the lease—had refunded the rental payment would the taxpayer be required under the tax benefit rule to recognize income on the subsequent destruction of the building. In other words, the subsequent recovery of the previously deducted rental payment would be the only event inconsistent with the provision allowing the deduction. It therefore is evident that the tax benefit rule must be applied on a case-by-case basis. A court must consider the facts and circumstances of each case in the light of the purpose and function of the provisions granting the deductions.

When the later event takes place in the context of a nonrecognition provision of the Code, there will be an inherent tension between the tax benefit rule and the nonrecognition provision. See Putoma Corp. v. Commissioner, 601 F.2d 734, 742 (CA5 1979); id., at 751 (Rubin, J., dissenting); cf. Helvering v. American Dental Co., 318 U.S. 322, 3 S.Ct. 577, 87 L.Ed. 785 (1943) (tension between exclusion of gifts from income and treatment of cancellation of indebtedness as income). We cannot resolve that tension with a blanket rule that the tax benefit rule will always prevail. Instead, we must focus on the particular provisions of the Code at issue in any case.20

The formulation that we endorse today follows clearly from the long development of the tax benefit rule. Justice STEVENS' assertion that there is no suggestion in the early cases or from the early commentators that the rule could ever be applied in any case that did not involve a physical recovery, post, at 406-408 is incorrect. The early cases frequently framed the rule in terms consistent with our view and irreconcilable with that of the dissent. See Barnett v. Commissioner, 39 B.T.A. 864, 867 (1939) ("Finally, the present case is analogous to a number of others, where . . . [w]hen some event occurs which is inconsistent with a deduction taken in a prior year, adjustment may have to be made by reporting a balancing item in income for the year in which the change occurs.") (emphasis added); Estate of Block v. Commissioner, 39 B.T.A. 338 (1939) ("When recovery or some other event which is inconsistent with what has been done in the past occurs, adjustment must be made in reporting income for the year in which the change occurs.") (emphasis added); South Dakota Concrete Products Co. v. Commissioner, 26 B.T.A. 1429, 1432 (1932) ("[W]hen an adjustment occurs which is inconsistent with what has been done in the past in the determination of tax liability, the adjustment should be reflected in reporting income for the year in which it occurs.") (emphasis added).21 The reliance of the dissent on the early commentators is equally misplaced, for the articles cited in the dissent, like the early cases, often stated the rule in terms of inconsistent events.22

Finally, Justice STEVENS' dissent relies heavily on the codification in § 111 of the exclusionary aspect of the tax benefit rule, which requires the taxpayer to include in income only the amount of the deduction that gave rise to a tax benefit, see note 12, supra. That provision does, as the dissent observes, speak of a "recovery." By its terms, it only applies to bad debts, taxes, and delinquency amounts. Yet this Court has held, Dobson v. Commissioner, 320 U.S. 489, 505-506, 64 S.Ct. 239, 248-249, 88 L.Ed. 248 (1943), and it has always been accepted since,23 that § 111 does not limit the application of the exclusionary aspect of the tax benefit rule. On the contrary, it lists a few applications and represents a general endorsement of the exclusionary aspect of the tax benefit rule to other situations within the inclusionary part of the rule. The failure to mention inconsistent events in § 111 no more suggests that they do not trigger the application of the tax benefit rule than the failure to mention the recovery of a capital loss suggests that it does not, see Dobson, supra.

Justice STEVENS also suggests that we err in recognizing transactional equity as the reason for the tax benefit rule. It is difficult to understand why even the clearest recovery should be taxed if not for the concern with transactional equity, see supra, at 377. Nor does the concern with transactional equity entail a change in our approach to the annual accounting system. Although the tax system relies basically on annual accounting, see Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365, 51 S.Ct. 150, 152, 75 L.Ed. 383 (1931), the tax benefit rule eliminates some of the distortions that would otherwise arise from such a system. See, e.g., Bittker and Kanner, The Tax Benefit Rule, 26 U.C.L.A.L.Rev. 265, 268-270 (1978); Tye 350; Plumb 178 and n. 172. The limited nature of the rule and its effect on the annual accounting principle bears repetition: only if the occurrence of the event in the earlier year would have resulted in the disallowance of the deduction can the Commissioner require a compensating recognition of income when the event occurs in the later year.24

Our approach today is consistent with our decision in Nash v. United States, 398 U.S. 1, 90 S.Ct. 1550, 26 L.Ed.2d 1 (1970). There, we rejected the Government's argument that the tax benefit rule required a taxpayer who incorporated a partnership under § 351 to include in income the amount of the bad debt reserve of the partnership. The Government's theory was that, although § 351 provides that there will be no gain or loss on the transfer of assets to a controlled corporation in such a situation, the partnership had taken bad debt deductions to create the reserve, see § 166(c), and when the partnership terminated, it no longer needed the bad debt reserve. We noted that the receivables were transferred to the corporation along with the bad debt reserve. Id., at 5 and n. 5, 90 S.Ct., at 1552 and n. 5. Not only was there no "recovery," id., at 4, 90 S.Ct., at 1552, but there was no inconsistent event of any kind. That the fair market value of the receivables was equal to the face amount less the bad debt reserve, id., at 4, reflected that the reserve, and the deductions that constituted it, were still an accurate estimate of the debts that would ultimately prove uncollectible, and the deduction was therefore completely consistent with the later transfer of the receivables to the incorporated business. See Citizens' Acceptance Corp. v. United States, 320 F.Supp. 798 (D.Del.1971), rev'd on other grounds, 462 F.2d 751 (CA3 1972); Rev.Rul. 78-279, 1978-2 Cum.Bull. 135; Rev.Rul. 78-278, 1978-2 Cum.Bull. 134; see generally O'Hare, Statutory Nonrecognition of Income and the Overriding Principle of the Tax Benefit Rule in the Taxation of Corporations and Shareholders, 27 Tax L.Rev. 215, 219-221 (1972).25

In the cases currently before us, then, we must undertake an examination of the particular provisions of the Code that govern these transactions to determine whether the deductions taken by the taxpayers were actually inconsistent with later events and whether specific nonrecognition provisions prevail over the principle of the tax benefit rule.26

In Hillsboro, the key provision is § 164(e).27 That section grants the corporation a deduction for taxes imposed on its shareholders but paid by the corporation. It also denies the shareholders any deduction for the tax. In this case, the Commissioner has argued that the refund of the taxes by the state to the shareholders is the equivalent of the payment of a dividend from Hillsboro to its shareholders. If Hillsboro does not recognize income in the amount of the earlier deduction, it will have deducted a dividend. Since the general structure of the corporate tax provisions does not permit deduction of dividends, the Commissioner concludes that the payment to the shareholders must be inconsistent with the original deduction and therefore requires the inclusion of the amount of the taxes as income under the tax benefit rule.

In evaluating this argument, it is instructive to consider what the tax consequences of the payment of a shareholder tax by the corporation would be without § 164(e) and compare them to the consequences under § 164(e). Without § 164(e), the corporation would not be entitled to a deduction, for the tax is not imposed on it. See Treas.Reg. § 1.164-1(a), 26 CFR § 1.164-1(a) (1982); Wisconsin Gas & Electric v. United States, 322 U.S. 526, 527-530, 64 S.Ct. 1106, 1107-1108, 88 L.Ed. 1434 (1944). If the corporation has earnings and profits, the shareholder would have to recognize income in the amount of the taxes, because a payment by a corporation for the benefit of its shareholders is a constructive dividend. See §§ 301(c), 316(a); e.g., Ireland v. United States, 621 F.2d 731, 735 (CA5 1980); B. Bittker & J. Eustice, Federal Income Taxation of Corporations and Shareholders ¶ 7.05 (4th ed. 1979). The shareholder, however, would be entitled to a deduction since the constructive dividend is used to satisfy his tax liability. Section 164(a)(2). Thus, for the shareholder, the transaction would be a wash: he would recognize the amount of the tax as income,28 but he would have an offsetting deduction for the tax. For the corporation, there would be no tax consequences, for the payment of a dividend gives rise to neither income nor a deduction. Section 311(a).

Under § 164(e), the economics of the transaction of course remain unchanged: the corporation is still satisfying a liability of the shareholder and is therefore paying a constructive dividend. The tax consequences are, however, significantly different, at least for the corporation. The transaction is still a wash for the shareholder; although § 164(e) denies him the deduction to which he would otherwise be entitled, he need not recognize income on the constructive dividend, Treas.Reg. § 1.164-7, 26 CFR § 1.164-7 (1982). But the corporation is entitled to a deduction that would not otherwise be available. In other words, the only effect of § 164(e) is to permit the corporation to deduct a dividend. Thus, we cannot agree with the Commissioner that, simply because the events here give rise to a deductible dividend, they cannot be consistent with the deduction. In at least some circumstances, a deductible dividend is within the contemplation of the Code. The question we must answer is whether § 164(e) permits a deductible dividend in these circumstances when, the money, though initially paid into the state treasury, ultimately reaches the shareholder—or whether the deductible dividend is available, as the Commissioner urges, only when the money remains in the state treasury, as properly assessed and collected tax revenue.

Rephrased, our question now is whether Congress, in granting this special favor to corporations that paid dividends by satisfying the liability of their shareholders, was concerned with the reason the money was paid out by the corporation or with the use to which it was ultimately put. Since § 164(e) represents a break with the usual rules governing corporate distributions, the structure of the Code does not provide any guidance on the reach of the provision. This Court has described the provision as "prompted by the plight of various banking corporations which paid and voluntarily absorbed the burden of certain local taxes imposed upon their shareholders, but were not permitted to deduct those payments from gross income." Wisconsin Gas & Electric Co. v. United States, 322 U.S., at 531, 64 S.Ct., at 1109 (footnote omitted). The section, in substantially similar form, has been part of the Code since the Revenue Act of 1921, 42 Stat. 227. The provision was added by the Senate, but its Committee Report merely mentions the deduction without discussing it, see S.Rep. No. 275, 67th Cong., 1st Sess. 19 (1921). The only discussion of the provision appears to be that between Dr. T.S. Adams and Senator Smoot at the Senate Hearings. Dr. Adams's statement explains why the states imposed the property tax on the shareholders and collected it from the banks, but it does not cast much light on the reason for the deduction. Hearings on H.R. 8245 before the Comm. on Finance, 67th Cong., 1st Sess. 250-251 (1921) (statement of Dr. T.S. Adams, tax advisor, Treasury Department). Senator Smoot's response, however, is more revealing:

I have been a director of a bank . . . for over 20 years. They have paid that tax ever since I have owned a share of stock in the bank. . . . I know nothing about it. I do not take 1 cent of credit for deductions, and the banks are entitled to it. They pay it out. Id., at 251 (emphasis added).

The payment by the corporations of a liability that Congress knew was not a tax imposed on them29 gave rise to the entitlement to a deduction; Congress was unconcerned that the corporations took a deduction for amounts that did not satisfy their tax liability. It apparently perceived the shareholders and the corporations as independent of one another, each "know[ing] nothing about" the payments by the other. In those circumstances, it is difficult to conclude that Congress intended that the corporation have no deduction if the state turned the tax revenues over to these independent parties. We conclude that the purpose of § 164(e) was to provide relief for corporations making these payments, and the focus of Congress was on the act of payment rather than on the ultimate use of the funds by the state. As long as the payment itself was not negated by a refund to the corporation, the change in character of the funds in the hands of the state does not require the corporation to recognize income, and we reverse the judgment below.30

The problem in Bliss is more complicated. Bliss took a deduction under § 162(a), so we must begin by examining that provision. Section 162(a) permits a deduction for the "ordinary and necessary expenses" of carrying on a trade or business. The deduction is predicated on the consumption of the asset in the trade or business. See Treas.Reg. § 1.162-3, 26 CFR § 1.162-3 (1982) ("Taxpayers . . . should include in expenses the charges for materials and supplies only in the amount that they are actually consumed and used in operation in the taxable year. . . .") (emphasis added.) If the taxpayer later sells the asset rather than consuming it in furtherance of his trade or business, it is quite clear that he would lose his deduction, for the basis of the asset would be zero, see, e.g., Spitalny v. United States, 430 F.2d 195 (CA9 1970), so he would recognize the full amount of the proceeds on sale as gain. See § 1001(a), (c). In general, if the taxpayer converts the expensed asset to some other, non-business use, that action is inconsistent with his earlier deduction, and the tax benefit rule would require inclusion in income of the amount of the unwarranted deduction. That non-business use is inconsistent with a deduction for an ordinary and necessary business expense is clear from an examination of the Code. While § 162(a) permits a deduction for ordinary and necessary business expenses, § 262 explicitly denies a deduction for personal expenses. In the 1916 Act, the two provisions were a single section. See § 5(a) (1st), 39 Stat. 756. The provision has been uniformly interpreted as providing a deduction only for those expenses attributable to the business of the taxpayer. See, e.g., Kornhauser v. United States, 276 U.S. 145, 48 S.Ct. 219, 72 L.Ed. 505 (1928); H.Rep., 75th Cong., 3d Sess. 46 (January 14, 1938) ("a taxpayer should be granted a reasonable deduction for the direct expenses he has incurred in connection with his income") (emphasis added); see generally, 1 B. Bittker, Federal Taxation of Income, Estates and Gifts § 20.2 (1981). Thus, if a corporation turns expensed assets to the analog of personal consumption, as Bliss did here—distribution to shareholders31—it would seem that it should take into income the amount of the earlier deduction.32

That conclusion, however, does not resolve this case, for the distribution by Bliss to its shareholders is governed by a provision of the Code that specifically shields the taxpayer from recognition of gain—§ 336. We must therefore proceed to inquire whether this is the sort of gain that goes unrecognized under § 336. Our examination of the background of § 336 and its place within the framework of tax law convinces us that it does not prevent the application of the tax benefit rule.33

Section 336 was enacted as part of the 1954 Code. It codified the doctrine of General Utilities Co. v. Helvering, 296 U.S. 200, 206, 56 S.Ct. 185, 187, 80 L.Ed. 154 (1935), that a corporation does not recognize gain on the distribution of appreciated property to its shareholders. Before the enactment of the statutory provision, the rule was expressed in the regulations, which provided that the corporation would not recognize gain or loss, "however [the assets] may have appreciated or depreciated in value since their acquisition." Income Tax Regulations 118, § 39.22(a)-20 (1953) (emphasis added). The Senate Report recognized this regulation as the source of the new § 336, S.Rep. No. 1622, 83d Cong., 2d Sess. 258 (1954), U.S.Code Cong. & Admin.News 1954, p. 4017. The House Report explained its version of the provision, "Thus, the fact that the property distributed has appreciated or depreciated in value over its adjusted basis to the distributing corporation will in no way alter the application of subsection (a) [providing nonrecognition]." H.R. No. 1337, 83d Cong., 2d Sess. at A90 (1954) (emphasis added), U.S.Code Cong. & Admin.News 1954, p. 4227. This background indicates that the real concern of the provision is to prevent recognition of market appreciation that has not been realized by an arm's-length transfer to an unrelated party rather than to shield all types of income that might arise from the disposition of an asset.

Despite the breadth of the nonrecognition language in § 336, the rule of nonrecognition clearly is not without exception. For instance, § 336 does not bar the recapture under §§ 1245 and 1250 of excessive depreciation taken on distributed assets. Sections 1245(a), 1250(a); Treas.Reg. §§ 1.1245-6(b), 1.1250-1(c)(2), 26 CFR §§ 1.1245-6(b), 1.1250-1(c)(2) (1982). Even in the absence of countervailing statutory provisions, courts have never read the command of nonrecognition in § 336 as absolute. The "assignment of income" doctrine has always applied to distributions in liquidation. See, e.g., Siegel v. United States, 464 F.2d 891 (CA9 1972), cert. dism'd, 410 U.S. 918, 93 S.Ct. 978, 35 L.Ed.2d 581 (1973); Williamson v. United States, 292 F.2d 524, 155 Ct.Cl. 279 (Ct.Cl.1961); see also Idaho First National Bank v. United States, 265 F.2d 6 (CA9 1959) (decided before General Utilities codified in § 336). That judicial doctrine prevents taxpayers from avoiding taxation by shifting income from the person or entity that earns it to someone who pays taxes at a lower rate.34 Since income recognized by the corporation is subject to the corporate tax and is again taxed at the individual level upon distribution to the shareholder, shifting of income from a corporation to a shareholder can be particularly attractive: it eliminates one level of taxation. Responding to that incentive, corporations have attempted to distribute to shareholders fully performed contracts or accounts receivable and then to invoke § 336 to avoid taxation on the income. In spite of the language of nonrecognition, the courts have applied the assignment of income doctrine and required the corporation to recognize the income.35 Section 336, then, clearly does not shield the taxpayer from recognition of all income on the distribution.

Next, we look to a companion provision—§ 337, which governs sales of assets followed by distribution of the proceeds in liquidation.36 It uses essentially the same broad language to shield the corporation from the recognition of gain on the sale of the assets. The similarity in language alone would make the construction of § 337 relevant in interpreting § 336. In addition, the function of the two provisions reveals that they should be construed in tandem. Section 337 was enacted in response to the distinction created by United States v. Cumberland Public Service Co., 338 U.S. 451, 70 S.Ct. 280, 94 L.Ed. 251 (1950), and Commissioner v. Court Holding, 324 U.S. 331, 65 S.Ct. 707, 89 L.Ed. 981 (1945). Under those cases, a corporation that liquidated by distributing appreciated assets to its shareholders recognized no income, as now provided in § 336, even though its shareholders might sell the assets shortly after the distribution. See Cumberland. If the corporation sold the assets, though, it would recognize income on the sale, and a sale by the shareholders after distribution in kind might be attributed to the corporation. See Court Holding. To eliminate the necessarily formalistic distinctions and the uncertainties created by Court Holding and Cumberland, Congress enacted § 337, permitting the corporation to adopt a plan of liquidation, sell its assets without recognizing gain or loss at the corporate level, and distribute the proceeds to the shareholders. The very purpose of § 337 was to create the same consequences as § 336. See Midland-Ross Corp. v. United States, 485 F.2d 110 (CA6 1973); S.Rep. No. 1622, supra, at 258.

There are some specific differences between the two provisions, largely aimed at governing the period during which the liquidating corporation sells its assets, a problem that does not arise when the corporation distributes its assets to its shareholders. For instance, § 337 does not shield the income produced by the sale of inventory in the ordinary course of business; that income will be taxed at the corporate level before distribution of the proceeds to the shareholders. See § 337(b). These differences indicate that Congress did not intend to allow corporations to escape taxation on business income earned while carrying on business in the corporate form; what it did intend to shield was market appreciation.

The question whether § 337 protects the corporation from recognizing income because of unwarranted deductions has arisen frequently, and the rule is now well established that the tax benefit rule overrides the nonrecognition provision. Connery v. United States, 460 F.2d 1130 (CA3 1972); Commissioner v. Anders, 414 F.2d 1283 (CA10), cert. denied, 396 U.S. 958 (1969); Krajeck v. United States, 75-1 USTC ¶ 9492 (D. ND 1975); S.E. Evans, Inc. v. United States, 317 F.Supp. 423 (D.Ark.1970); Anders v. United States, 462 F.2d 1147 (Ct.Cl.), cert. denied, 409 U.S. 1064, 93 S.Ct. 557, 34 L.Ed.2d 517 (1972); Estate of Munter v. Commissioner, 63 T.C. 663 (1975); Rev.Rul. 61-214, 1961-2 Cum.Bull. 60; Byrne, The Tax Benefit Rule as Applied to Corporate Liquidations: Recent Developments, 56 Notre Dame Law. 215, 221 (1980); Note, Tax Treatment of Previously Expensed Assets in Corporate Liquidations, 80 Mich.L.Rev. 1636, 1638-39 (1982); cf. Spitalny v. United States, supra, 430 F.2d 195 (when deduction and liquidation occur within a single year, though tax benefit rule does not apply, principle does). Congress has recently undertaken major revisions of the Code, see Economic Tax Recovery Act of 1981, Pub. 97-34, 95 Stat. 172, and has made changes in the liquidation provisions, e.g., Pub. 95-600, 92 Stat. 2904 (amending § 337); Pub. 95-628, 92 Stat. 3628 (same), but it did not act to change this long-standing, universally accepted rule. If the construction of the language in section 337 as permitting recognition in these circumstances has the acquiescence of Congress, Lorillard v. Pons, 434 U.S. 575, 580, 98 S.Ct. 866, 869, 55 L.Ed.2d 40 (1978), we must conclude that Congress intended the same construction of the same language in the parallel provision in § 336.

Thus, the legislative history of § 336, the application of other general rules of tax law, and the construction of the identical language in § 337 all indicate that § 336 does not permit a liquidating corporation to avoid the tax benefit rule. Consequently, we reverse the judgment of the Court of Appeals and hold that, on liquidation, Bliss must include in income the amount of the unwarranted deduction.37

Bliss paid the assessment on an increase of $60,000 in its taxable income. In the District Court, the parties stipulated that the value of the grain was $56,565, but the record does not show what the original cost of the grain was or what portion of it remained at the time of liquidation. The proper increase in taxable income is the portion of the cost of the grain attributable to the amount on hand at the time of liquidation. In Bliss, then, we remand for a determination of that amount. In Hillsboro, the taxpayer sought a redetermination in the Tax Court rather than paying the tax, so no further proceedings are necessary, and the judgment of the Court of Appeals is reversed.

It is so ordered.

Justice BRENNAN, dissenting in No. 81-485.

I join Parts I, II, and IV of the Court's opinion. For the reasons expressed in Part I of Justice BLACKMUN's dissenting opinion, however, I believe that a proper application of the principles set out in Part II of the Court's opinion would require an affirmance rather than a reversal in No. 81-485.

Justice STEVENS, with whom Justice MARSHALL joins, concurring in the judgment in No. 81-485 and dissenting in No. 81-930.

These two cases should be decided in the same way. The taxpayer in each case is a corporation. In 1972 each taxpayer made a deductible expenditure, and in 1973 its shareholders received an economic benefit. Neither corporate taxpayer ever recovered any part of its 1972 expenditure. In my opinion, the benefits received by the shareholders in 1973 are matters that should affect their returns; those benefits should not give rise to income on the 1973 return of the taxpayer in either case.

Both cases require us to apply the tax benefit rule. This rule has always had a limited, but important office: it determines whether certain events that enrich the taxpayer—recoveries of past expenditures—should be characterized as income.1 It does not create income out of events that do not enhance the taxpayer's wealth.

Today the Court declares that the purpose of the tax benefit rule is "to approximate the results produced by a tax system based on transactional rather than annual accounting." Ante, at 381. Whereas the rule has previously been used to determine the character of a current wealth-enhancing event, when viewed in the light of past deductions, the Court now suggests that the rule requires a study of the propriety of earlier deductions, when viewed in the light of later events. The Court states that the rule operates to "cancel out" an earlier deduction if the premise on which it is based is "fundamentally inconsistent" with an event in a later year. Ante, at 383.2

The Court's reformulation of the tax benefit rule constitutes an extremely significant enlargement of the tax collector's powers. In order to identify the groundbreaking character of the decision, I shall review the history of the tax benefit rule. I shall then discuss the Bliss Dairy case in some detail, to demonstrate that it fits comfortably within the class of cases to which the tax benefit rule has not been applied in the past. Finally, I shall explain why the Court's adventure in lawmaking is not only misguided but does not even explain its inconsistent disposition of these two similar cases.

* What is today called the "tax benefit rule" evolved in two stages, reflecting the rule's two components. The "inclusionary" component requires that the recovery within a taxable year of an item previously deducted be included in gross income. The "exclusionary component," which gives the rule its name, allows the inclusionary component to operate only to the extent that the prior deduction benefited the taxpayer.

The inclusionary component of the rule originated in the Bureau of Internal Revenue in the context of recoveries of debts that had previously been deducted as uncollectable. The Bureau sensed that it was inequitable to permit a taxpayer to characterize the recovery of such a debt as "return of capital" when in a prior year he had been allowed to reduce his taxable income to compensate for the loss of that capital. As one commentator described it, "[T]he allowance of a deduction results in a portion of gross income not being taxed; when the deducted item is recouped, the recovery stands in the place of the gross income which had not been taxed before and is therefore taxable."3 This principle was quickly endorsed by the Board of Tax Appeals and the courts. See Excelsior Printing Co. v. Commissioner, 16 B.T.A. 886 (1929); Putnam National Bank v. Commissioner, 50 F.2d 158 (CA5 1931).

The exclusionary component was not so readily accepted. The Bureau first incorporated it during the Great Depression as the natural equitable counterweight to the inclusionary component. G.C.M. 18525, 1937-1 Cum.Bull. 80. It soon retreated, however, insisting that a recovery could be treated as income even if the prior deduction had not benefited the taxpayer. G.C.M. 22163, 1940-2 Cum.Bull. 76. The Board of Tax Appeals protested, e.g., Corn Exchange Nat'l Bank & Trust Co. v. Commissioner, 46 B.T.A. 1107 (1942), but the Circuit Courts of Appeals sided with the Bureau. Helvering v. State-Planters Bank & Trust Co., 130 F.2d 44 (CA4 1942); Commissioner v. United States & International Securities Corp., 130 F.2d 894 (CA3 1942). At that point, Congress intervened for the first and only time. It enacted the forerunner of § 111 of the present Code, ch. 619, Title I, § 116(a), Act of Oct. 21, 1942, 56 Stat. 812, using language that by implication acknowledges the propriety of the inclusionary component by explicitly mandating the exclusionary component.4

The most striking feature of the rule's history is that from its early formative years, through codification, until the 1960's, Congress,5 the Internal Revenue Service,6 courts,7 and commentators,8 understood it in essentially the same way. They all saw it as a theory that appropriately characterized certain recoveries of capital as income. Although the rule undeniably helped to accommodate the annual accounting system to multi-year transactions, I have found no suggestion that it was regarded as a generalized method of approximating a transactional accounting system through the fabrication of income at the drop of a fundamentally inconsistent event.9 An inconsistent event was always a necessary condition, but with the possible exception of the discussion of the Board of Tax Appeals in Barnett v. Commissioner, 39 B.T.A. 864, 867 (1939), inconsistency was never by itself a sufficient reason for applying the rule.10 Significantly, the first case from this Court dealing with the tax benefit rule emphasized the role of a recovery.11 And when litigants in this Court suggested that a transactional accounting system would be more equitable, we expressly declined to impose one, stressing the importance of finality and practicability in a tax system.12

In the 1960's, the Commissioner, with the support of some commentators and the Tax Court, began to urge that the Tax Benefit Rule be given a more ambitious office.13 In Nash v. United States, 398 U.S. 1, 90 S.Ct. 1550, 26 L.Ed.2d 1 (1970), the Commissioner argued that the rule should not be limited to cases in which the taxpayer had made an economic recovery, but rather should operate to cancel out an earlier deduction whenever later events demonstrate that the taxpayer is no longer entitled to it. The arguments advanced, and rejected, in that case were remarkably similar to those found in the Court's opinion today.14

The Nash case arose out of the sale of a partnership business to a corporation. The partnership had taken deductions for ledger entries in a "bad debt reserve"—an account that reflected the firm's estimate of its future losses from accounts receivable that would eventually become uncollectable. When the partnership business was sold to a corporation, the Commissioner sought to apply the Tax Benefit Rule, arguing that even though the partnership had made no recovery of the amount in the bad debt reserve, the deductibility of the pre-sale additions to the taxpayer's reserve had been justified on the basis of an assumption that was no longer valid after the business was sold.15

This Court flatly rejected the Commissioner's position. Rather than scrutinizing the premises of the prior deduction in the light of subsequent events, the Court used the subsequent events themselves as its starting point. Since the transfer of the bad debt reserve did not enrich the taxpayer, there was no current realization event justifying the application of the tax benefit rule. "[A]lthough the 'need' for the reserve ended with the transfer, the end of that need did not mark a 'recovery' within the meaning of the tax benefit cases." Id., at 5, 90 S.Ct., at 1552.16

Today, the Court again has before it a case in which the Commissioner, with the endorsement of some commentators and a closely divided Tax Court, is pushing for a more ambitious tax benefit rule.17 This time, the Court accepts the invitation. Since there has been no legislation since Nash suggesting that our approach over the past half-century18 has been wrong-headed, cf. n. 32, infra, the new doctrine that emerges from today's decision is of the Court's own making.

In the Bliss Dairy case, the Court today reaches a result contrary to that dictated by a recovery theory. One would not expect such a break with the past unless it were apparent that prior law would produce a palpable inequity—a clear windfall for the taxpayer. Yet that is not the case in Bliss Dairy. Indeed, the tax economics of the case are indistinguishable from those of the Nash case.

Three statutory provisions, as interpreted by the Commissioner, interact in Bliss Dairy. First, pursuant to § 162(a),19 the Commissioner allowed the corporation to deduct the entire cost of all grain purchased in 1972. That deduction left it with a basis of zero in that grain. Second, under the terms of § 336,20 the corporation was not required to recognize any gain or loss when it went through a § 333 liquidation in 1973. And third, pursuant to the regulations implementing § 334,21 the shareholders were allowed to assign some portion of their basis in the corporation's stock to the grain they received in the liquidation. Admittedly, this combination of provisions could in some cases cause a "step-up" in the grain's basis that is not reflected in the income of either the corporation or the shareholders. That possibility figured strongly in the decision of the Court of Appeals for the Sixth Circuit to endorse an inconsistent event theory in a precursor of this case. See Tennessee-Carolina Transportation, Inc. v. Commissioner, 582 F.2d 378, 382 and n. 14 (CA6 1978). And it is stressed by the Solicitor General in his argument in this case. Brief for United States 39-42. Yet close analysis reveals that the potential untaxed step-up is not the sort of extraordinary and inequitable windfall that calls for extraordinary measures in this case.

As a factual matter, the record does not include the tax returns of Bliss Dairy's shareholders. We have no indication of how much, if any, step-up in basis actually occurred. And as a legal matter, a § 333 liquidation expressly contemplates steps-up in basis that are not reflected in income. Thus, even if the corporation had behaved as the Court believes it should have and had fed all the grain to the cows before liquidating, whatever shareholder stock basis was assigned to the grain in this case would have been used to step up the basis of some other asset that passed to the shareholders in the liquidation.

I suppose it might be argued that this sort of untaxed step-up is acceptable if it happens accidentally, but not if a taxpayer manipulates business transactions solely to take advantage of it. Yet here again we have too little information to conclude that there has been any such manipulation in the case of Bliss Dairy. To begin with, the Government has never questioned the propriety of the 1972 deduction, viewed in the light of 1972 events.22 Moreover, the record before us on appeal does not tell us how much feed the Dairy's cattle consumed in 1972, whether 1972 consumption exceeded 1972 purchases, or how the volume purchased in 1972 compared with purchases in prior years. Indeed, it is quite possible that in 1971 the Dairy had made abnormally large purchases as a hedge against a possible rise in the market price, and that its 1972 consumption of grain actually exceeded its $150,000 in purchases during that year.

It is no doubt for these reasons that the Court never relies on the untaxed step-up argument in its opinion today.23 Unfortunately, the only argument the Court offers in its place is an ipse dixit: it seems wrong for a taxpayer not to realize income if it fails to use up an asset, when it was allowed to deduct the value of that asset in a prior year. We rejected that precise proposition in Nash. In both Nash and Bliss Dairy, the transfer of the business in a subsequent year revealed that a business asset matching a prior deduction (i.e., grain matching the expense deduction, or the account receivable matching the bad debt deduction) would not be used up (i.e., consumed or become uncollectable) until it had passed to a different taxpayer.24 The only explanation for today's decision to detach the tax benefit rule from the recovery mooring appears to be the challenge to be found in an open sea of troublesome and inconclusive hypothetical cases.25

Because tax considerations play such an important role in decisions relating to the investment of capital, the transfer of operating businesses, and the management of going concerns, there is a special interest in the orderly, certain and consistent interpretation of the Internal Revenue Code. Today's decision seriously compromises that interest. It will engender uncertainty, it will enlarge the tax gatherer's discretionary power to reexamine past transactions, and it will produce controversy and litigation.

Any inconsistent event theory of the tax benefit rule would make the tax system more complicated than it has been under the recovery theory.26 Inconsistent event analysis forces a deviation from the traditional pattern of calculating income during a given year: identify the transactions in which the taxpayer was made wealthier, determine from the history of those transactions which apparent sources of enrichment should be characterized as income, and then determine how much of that income must be recognized. Of course, in several specific contexts, Congress has already mandated deviations from that traditional pattern,27 and the additional complications are often deemed an appropriate price for enhanced tax equity. But to my knowledge Congress has never even considered so sweeping a deviation as a general inconsistent events theory.

Nonetheless, a general inconsistent events theory would surely give more guidance than the vague hybrid established by the Court today. The dimensions of the Court's newly fashioned "fundamentally inconsistent event" version of the tax benefit rule are by no means clear. It obviously differs from both the Government's "inconsistent event" theory and the familiar "recovery" theory, either of which would require these two cases to be decided in the same way. I do not understand, however, precisely why the Court's theory distinguishes between these cases, or how it is to be applied in computing the 1973 taxes of Bliss Dairy, Inc.

The Government describes its test as whether "subsequent events eliminate the factual premise on which the deduction was originally claimed." Brief for United States 18. The Court describes its test as whether "the later event is indeed fundamentally inconsistent with the premise on which the deduction was initially based." Ante, at 383. One might infer that the difference between these tests is a difference between "inconsistent events" and "fundamentally inconsistent events." The Court attempts to place the line more precisely "between merely unexpected events and inconsistent events." Ante, at 383, n. 15. I am afraid the attempt fails because, however it is described, the line does not cleanly and predictably separate the Court's position from the Government's.

The Court presents its test as whether "the occurrence of the [later year's] event in the earlier year would have resulted in the disallowance of the deduction." Ante, at 389. But in Hillsboro, the Court rejects the Government's claim. The Court holds that if this Court had decided Lehnhausen in 1972, the Bank would still have been entitled to deduct a dividend that was not used for the payment of taxes. It attempts to read the legislative history of § 164(e) as establishing that Congress did not care about the use to which the dividend payment was put, but only about the bank's reason for the dividend. I would simply note that I find Justice BLACKMUN's interpretation of § 164(e) far more plausible.

The Court's analysis of Bliss Dairy is equally unsatisfying. Without any mention of a same-year principle, the Court resolves the case in a single sentence: a § 336 liquidation is assimilated to a dividend distribution, which is deemed "the analog of personal consumption," and therefore "it would seem that it should take into income the amount of the earlier deduction." Ante, at 396 and n. 31.28 It is not obvious to me why the change in ownership of a going concern is more "the analog of personal consumption" than the gift of an asset.

The new rule will create even more confusion than that which will accompany efforts to reconcile the Court's disposition of these two cases. Given that Nash is still considered good law by the Court, it is not clear which prior expenses of Bliss Dairy, Inc., will give rise to income in 1973. Presumably, all expenses for the purchase of tangible supplies will be treated like the cattle feed. Thus, all corporate paper towels, paper clips, and pencils that remain on hand will become income as a result of the liquidation. It is not clear, however, how the Court would react to other expenses that provide an enduring benefit. I find no limiting principle in the Court's opinion that distinguishes cattle feed and pencils from prepaid rent, prepaid insurance, accruals of employee vacation time, advertising, management training, or any other expense that will have made the going concern more valuable when it is owned directly by its shareholders.

The Court's opinion also leaves unclear the amount of income that is realized in the year in which the fundamentally inconsistent event occurs. In most of its opinion, the Court indicates that the taxpayer is deemed to realize "the amount of his earlier deduction," ante, at 383, but from time to time the Court equivocates,29 and at least once suggests that when an expensed asset is sold, only the "amount of the proceeds on sale," ante, at 395, is income.30 Even in Bliss Dairy, which involves a revolving inventory of a fungible commodity, I am not sure how the Court requires the "cost" of the grain, ante, at 403, to be computed. If the corporation's 1972 consumption matched its 1972 purchases, one might think that the relevant cost was that in the prior years when the surplus was built up. I cannot tell whether or why the fundamentally inconsistent event theory prefers LIFO accounting over FIFO.

Neither history nor sound tax policy supports the Court's abandonment of its interpretation of the tax benefit rule as a tool for characterizing certain recoveries as income. If Congress were dissatisfied with the tax treatment that I believe Bliss Dairy should be accorded under current law, it could respond by changing any of the three provisions that bear on this case. See supra, at 413. It could modify the manner in which deductions are authorized under § 162.31 It could legislate another statutory exception to the annual accounting system, much as it did when it made the depreciation recapture provisions, §§ 1245, 1250, apply to § 336 liquidations.32 Or it could modify the manner in which basis is allocated under § 334.33 But in the absence of legislative action, I cannot join in the Court's attempt to achieve similar results by distorting the tax benefit rule.34

Accordingly, I concur in the Court's judgment in No. 81-485 and respectfully dissent in No. 81-930.

Justice BLACKMUN, dissenting.

These consolidated cases present issues concerning the so-called "tax benefit rule" that has been developed in federal income tax law. In No. 81-485, the Court concludes that the rule has no application to the situation presented. In No. 81-930, it concludes that the rule operates to the detriment of the taxpayer with respect to its later tax year. I disagree with both conclusions.

* In No. 81-485, the Court interprets § 164(e) of the Internal Revenue Code of 1954, 26 U.S.C. § 164(e). See ante, at 392-395. It seems to me that the propriety of a 1972 deduction by the Bank under § 164(e) depended upon the payment by the Bank of a state tax on its shares. This Court's decision in Lehnhausen v. Lake Shore Auto Parts Co., 410 U.S. 356, 93 S.Ct. 1001, 35 L.Ed.2d 351 (1973), rendered any such tax nonexistent and any deduction therefore unavailable. I sense no "focus of Congress . . . on the act of payment rather than on the ultimate use of the funds by the State." Ante, at 394. The focus, instead, is on the payment of a tax. Events proved that there was no tax. The situation, thus, is one for the application, not the nonapplication, of some tax benefit rule.

I therefore turn to the question of the application of a proper rule in each of these cases.

The usual rule, as applied to a deduction, appears to be this: Whenever a deduction is claimed, with tax benefit, in a taxpayer's federal return for a particular tax year, but factual developments in a later tax year prove the deduction to have been asserted mistakenly in whole or in part, the deduction, or that part of it which the emerging facts demonstrate as excessive, is to be regarded as income to the taxpayer in the later tax year. With that general concept (despite occasionally expressed theoretical differences between "transactional parity" or "transactional inconsistency," on the one hand, and, on the other, a need for a "recovery") I have no basic disagreement.

Regardless of the presence of § 111 in the Internal Revenue Code of 1954, 26 U.S.C. § 111, it is acknowledged that the tax benefit rule is judge-made. See, e.g., 1 J. Mertens, Law of Federal Income Taxation, § 7.34, p. 114 (rev. ed. 1981); Bittker and Kanner, The Tax Benefit Rule, 26 UCLA L.Rev. 265, 266 (1978). It came into being, apparently, because of two concerns: 1) a natural reaction against an undeserved and otherwise unrecoverable (by the Government) tax benefit, and 2) a perceived need, because income taxes are payable at regular intervals, to promote the integrity of the annual tax return. Under this approach, if a deduction is claimed, with some justification, in an earlier tax year, it is to be allowed in that year, even though developments in a later year show that the deduction in the earlier year was undeserved in whole or in part. This impropriety is then counterbalanced (concededly in an imprecise manner, see ante, at 378, n. 10, and 380-381, n. 12) by the inclusion of a reparative item in gross income in the later year. See Burnet v. Sanford & Brooks Co., 282 U.S. 359, 51 S.Ct. 150, 75 L.Ed. 383 (1931); Healy v. Commissioner, 345 U.S. 278, 73 S.Ct. 671, 97 L.Ed. 1007 (1953).* In

__________ Nash v. United States, 398 U.S. 1, 3, 90 S.Ct. 1550, 1551, 26 L.Ed.2d 1 (1970), the Court succinctly phrased it this way: "[A] recovery of an item that has produced an income tax benefit in a prior year is to be added to income in the year of recovery."

I have no problem with the rule with respect to its first underlying concern (the rectification of an undeserved tax benefit). When a taxpayer has received an income tax benefit by claiming a deduction that later proves to be incorrect or, in other words, when the premise for the deduction is destroyed, it is only right that the situation be corrected so far as is reasonably possible, and that the taxpayer not profit by the improper deduction. I am troubled, however, by the tendency to carry out the second concern (the integrity of the annual return) to unnecessary and undesirable limits. The rule is not that sacrosanct.

In No. 81-485, Hillsboro National Bank, in its 1972 return, took as a deduction the amount of assessed state property taxes the Bank paid that year on its stock held by its shareholders; this deduction, were there such a tax, was authorized by the unusual, but nevertheless specific, provisions of § 164(e) of the Code, 26 U.S.C. § 164(e). The Bank received a benefit by the deduction, for its net income and federal income tax were reduced accordingly. Similarly, in No. 81-930, Bliss Dairy, Inc., which kept its books and filed its returns on the cash receipts and disbursements method, took a deduction in its return for its fiscal year ended June 30, 1973, for cattle feed it had purchased that year. That deduction was claimed as a business expense under § 162(a) of the Code, 26 U.S.C. § 162(a). The Dairy received a tax benefit, for its net income and federal income tax for fiscal 1973 were reduced by the deduction. Thus far, everything is clear and there is no problem.

In the Bank's case, however, a subsequent development, namely, the final determination by this Court in 1973 in Lehnhausen, supra, that the 1970 amendment of the Illinois Constitution, prohibiting the imposition of the state property taxes in question, was valid, eliminated any factual justification for the 1972 deduction. And, in the Dairy's case, a post-fiscal year 1973 development, namely, the liquidation of the corporation and the distribution of such feed as was unconsumed on June 30, 1973, to its shareholders, with their consequent ability to deduct, when the feed thereafter was consumed, the amount of their adjusted basis in that feed, similarly demonstrated the impropriety of the Dairy's full-cost deduction in fiscal 1973.

I have no difficulty in favoring some kind of "tax benefit" adjustment in favor of the Government for each of these situations. An adjustment should be made, for in each case the beneficial deduction turned out to be improper and undeserved because its factual premise proved to be incorrect. Each taxpayer thus was not entitled to the claimed deduction, or a portion of it, and this nonentitlement should be reflected among its tax obligations.

This takes me, however, to the difficulty I encounter with the second concern, that is, the unraveling or rectification of the situation. The Commissioner and the United States in these respective cases insist that the Bank and the Dairy should be regarded as receiving income in the very next tax year when the factual premise for the prior year's deduction proved to be incorrect. I could understand that position, if, in the interim, the bar of a statute of limitations had become effective or if there were some other valid reason why the preceding year's return could not be corrected and additional tax collected. But it seems to me that the better resolution of these two particular cases and others like them—and a resolution that should produce little complaint from the taxpayer—is to make the necessary adjustment, whenever it can be made, in the tax year for which the deduction was originally claimed. This makes the correction where the correction is due and it makes the amount of net income for each year a true amount and one that accords with the facts, not one that is structured, imprecise, and fictional. This normally would be accomplished either by the taxpayer's filing an amended return for the earlier year, with payment of the resulting additional tax, or by the Commissioner's assertion of a deficiency followed by collection. This actually is the kind of thing that is done all the time, for when a taxpayer's return is audited and a deficiency is asserted due to an overstated deduction, the process equates with the filing of an amended return.

The Dairy's case is particularly acute. On July 2, 1973, on the second day after the end of its fiscal year, the Dairy adopted a plan of liquidation pursuant to § 333 of the Code, 26 U.S.C. § 333. That section requires the adoption of a plan of liquidation; the making and filing, within 30 days, of written elections by the qualified electing shareholders; and the effectuation of the distribution in liquidation within a calendar month. §§ 333(a), (c), and (d). It seems obvious that the Dairy, its management, and its shareholders, by the end of the Dairy's 1973 fiscal year on June 30, and certainly well before the filing of its tax return for that fiscal year, all had conceived and developed the July 2, 1973, plan of liquidation and were resolved to carry out that plan with the benefits that they felt would be afforded by it. Under these circumstances, we carry the tax benefit rule too far and apply it too strictly when we utilize the unconsumed feed to create income for the Dairy for fiscal 1974 (the month of July 1973), instead of decreasing the deduction for the same feed in fiscal 1973. Any concern for the integrity of annual tax reporting should not demand that much. I thus would have the Dairy's returns adjusted in a realistic and factually true manner, rather than in accord with an inflexibly-administered tax benefit rule.

Much the same is to be said about the Bank's case. The decisive event, this Court's decision in Lehnhausen, occurred on Feb. 22, 1973, within the second month of the Bank's 1973 tax year. Indeed, it took place before the Bank's calendar year 1972 return would be overdue. Here again, an accurate return for 1972 should be preferred over inaccurate returns for both 1972 and 1973.

This, in my view, is the way these two particular tax controversies should be resolved. I see no need for anything more complex in their resolution than what I have outlined. Of course, if a statute of limitations problem existed, or if the facts in some other way prevented reparation to the Government, the cases and their resolution might well be different.

I realize that my position is simplistic, but I doubt if the judge-made tax benefit rule really was intended, at its origin, to be regarded as applicable in simple situations of the kind presented in these successive-tax-year cases. So often a judge-made rule, understandably conceived, ultimately is used to carry us farther than it should.

I would vacate the judgment in each of these cases and remand each case for further proceedings consistent with this analysis.