On Appeal from the United States Tax Court
Before Swygert, Circuit Judge, Wisdom, Senior Circuit Judge,*fn* and Pell, Circuit Judge.
The issue on this appeal is whether the petitioner, Hillsboro National Bank, realized income under the tax benefit rule when state personal property taxes it had paid on behalf of its stockholders and deducted from its income for federal income tax purposes in 1972 were refunded directly to the stockholders in 1973. We hold that the refunds were income to the Bank, and we affirm the ruling of the Tax Court.
This case concerns the remarkable recent history of the Illinois personal property tax. Before 1971, stockholders of any incorporated bank located within Illinois were subject to a personal property tax on the value of their shares. The banks were required to retain dividends sufficient to pay such taxes. Ill.Rev.Stat. ch. 120, §§ 557, 558. Rather than retaining dividends, Illinois banks customarily paid these taxes out of general funds on their stockholders' behalf. They did not receive reimbursement from the stockholders. Conceptually these tax payments on the stockholders' behalf are a form of constructive dividend. Nevertheless, the Internal Revenue Code permits the banks to deduct such payments from their corporate incomes. I.R.C. § 164(e) (1976).
Effective January 1, 1971, Illinois amended its constitution to abolish the personal property tax as to individual taxpayers. Ill.Const. art. IX-A. In July 1971, the Illinois Supreme Court struck down this amendment as a violation of the equal protection clause of the fourteenth amendment and reinstated the tax on all taxpayers. Lake Shore Auto Parts Co. v. Korzen, 49 Ill.2d 137, 273 N.E.2d 592 (1971). The United States Supreme Court granted certiorari in the case. Faced with this unsettled situation, the Illinois legislature passed an interim measure directing that the taxes in dispute should be paid into an interest-bearing escrow account. If the abolition of the tax was ultimately upheld, the taxes thus paid would be refunded to the taxpayers. Ill.Rev.Stat. ch. 120, § 676.01. Accordingly, on July 7, 1972, Hillsboro National Bank paid $26,110.32 in satisfaction of the 1971 personal property tax owed by the Bank's individual stockholders on their Hillsboro shares. The bank deducted this amount on its 1972 federal income tax return under I.R.C. § 164(e).
In February 1973 the United States Supreme Court reversed the Illinois court's decision and held that the abolition of the tax is constitutional. Lehnhausen v. Lake Shore Auto Parts Co., 410 U.S. 356, 93 S. Ct. 1001, 35 L. Ed. 2d 351 (1973). Accordingly, the County Treasurer of Montgomery County refunded the money the Bank had erroneously paid, plus interest. The Treasurer issued the refund checks directly to the Bank's stockholders, payable only to them. The Bank was neither consulted by the Treasurer nor informed of his action.
The Bank did not report any part of the 1973 refund as income. The Commissioner issued a notice of deficiency, alleging that the Bank should have reported the refund as income on its 1973 federal income tax return. The Bank petitioned the U.S. Tax Court for relief. Deciding the case on stipulations and briefs, the Tax Court entered judgment for the Commissioner.
We conclude that this case is squarely controlled by our decision in First Trust & Savings Bank v. United States, 614 F.2d 1142 (7th Cir. 1980). First Trust arose out of the same confusion over the Illinois personal property tax as this case. There, as here, the plaintiff bank paid the tax on behalf of its individual stockholders in 1972, and the state refunded the tax to the stockholders in 1973. We held that the tax benefit rule*fn1 required First Trust to report the refund as 1973 income, even though the bank itself did not pocket a penny of it.
First Trust and this case are identical on their facts, except for one detail:*fn2 In First Trust the state refund checks named the bank as joint payee with its stockholders, while here the refund checks were made payable to the stockholders alone. This difference had no effect on the parties' substantive entitlements to the funds, for the bank in First Trust was obligated to pay the refunds over to the stockholders, Lincoln National Bank v. Cullerton, 18 Ill.App.3d 953, 958-59, 310 N.E.2d 845, 849 (1974). Despite the purely formal character of the difference, the Bank contends that it distinguishes this case from First Trust. The tax benefit rule applied in First Trust, the Bank argues, because the taxpayer bank there, as joint payee, made an "actual recovery" of the previously deducted state tax.
This argument gives too narrow a reading to our construction of the tax benefit rule in First Trust. We held unambiguously that the rule applies in any case where there is either an actual recovery of a previously deducted amount or some other event inconsistent with that prior deduction. 614 F.2d at 1145-46 & n.5; accord, Tennessee-Carolina Transportation, Inc. v. Commissioner, 582 F.2d 378 (6th Cir. 1978), cert. denied, 440 U.S. 909, 99 S. Ct. 1219, 59 L. Ed. 2d 457 (1979); see Block v. Commissioner, 39 B.T.A. 338 (1939), aff'd sub nom. Union Trust Co. v. Commissioner, 111 F.2d 60 (7th Cir.), cert. denied, 311 U.S. 658, 61 S. Ct. 12, 85 L. Ed. 421 (1940). Hence, the taxpayer bank in First Trust was held liable on either of two alternative grounds: first, that the bank actually recovered the state refund as joint payee; and second, that the refund was a later event patently inconsistent with the deduction taken under § 164(e). 614 F.2d at 1146.
Clearly, the latter of these two grounds applies foursquare in this case. Illinois, by refunding the state property tax to the stockholders, transformed a tax payment deductible under § 164(e) into a nondeductible cash dividend to the Bank's stockholders. Contrary to the Bank's contention, the tax benefit rule does not hinge upon whether the taxpayer "participates" in the later inconsistent event. The point is that the taxpayer has gained a windfall by taking a deduction that later developments show to have been unjustified.
PELL, Circuit Judge, dissenting.
Essentially, the majority members of the panel in this case, without any real analysis of the merits, feel themselves bound by this court's opinion in First Trust & Savings Bank v. United States, 614 F.2d 1142 (7th Cir. 1980). Ordinarily, even though I regard First Trust as having been incorrectly decided, I would likewise feel bound by a prior applicable opinion of this court, particularly one as recent as First Trust. Because, however, I regard that case as distinguishable, I respectfully dissent.
Both in First Trust, 614 F.2d at 1146, and in the majority opinion in the present case, there is a reference to the taxpayer bank having secured a "windfall." This just is not so. The taxpayer did, of course, take the deduction to which it was entitled by the revenue code.*fn1 While it got the benefit in the year the tax was paid this was nothing more than the ordinary situation in which a taxpayer is permitted a deduction for a state tax it has paid. That tax, however, was imposed not on the bank but was a tax on the individual shareholders of the bank. State statutes, such as the Illinois statute here involved,*fn2 made the bank liable for the tax on the shareholders' shares if the shareholders didn't pay the tax. Because of the obvious exposure resulting from some shareholders not getting around to paying a traditionally unpopular tax on intangible personal property, the banks, at least, from the early part of this century, have voluntarily paid all the tax owing by all of their shareholders. Yet, even though the tax would have been deductible if it had been paid directly ...