An impromptu lecture of some length and great passion followed. It concluded with an exclamation point that since the income tax was a product of politics and subject to interpretation by judges--most of whom had little economic sense and virtually no accounting knowledge--one could never, under any circumstances expect or rely on the income tax rules making any sense at all.

A few years later, at age 53, dad graduated from law school. His opinions had changed little.

My father died in 1985 while serving as inspector general of the U.S. Department of Interior, but his observation back then proved true and lives on. Dad--along with myriad other commentators over the years--also pointed out that lousy facts make for bad law.

The Owen Decision
Recently, the Owen decision (John W. Owen, et ux. v. U.S. 83 AFTR 2d Par. 99-356) has given us a law that is not only inconsistent and illogical, but carries a decidedly worrisome outcome.

Mr. and Mrs. Owen were cash-basis taxpayers that made $225,000 in improvements to their office condominiums and added these amounts to their basis, thus affecting the calculation of profits when the condominiums were sold. But rather than offering cash as payment for the improvements, they instead gave the contractor three promissory notes.

In reading the case, it appears evident that what got the Owens to court with Internal Revenue Service, among other matters at issue, was the fact that the promissory notes were issued to a company apparently controlled by Mr. Owen. Moreover, those notes apparently remained unpaid at the date the property was sold.

Clearly adding insult to injury, the Owens did not include the improvements in their basis at the time of the 1987 original sale of the condos. Instead, they sought to include additional tax basis on claims for refund filed in 1993 and--to make matters even sillier--Mr. Owens evidently testified at trial that he never paid the notes (apparently demonstrating self-righteous chutzpah).

Instead of tossing out the claim as a sham or disallowing the improvements as basis under a pre-arranged debt forgiveness theory, the court--in its infinite wisdom--chose instead to analyze the Internal Revenue Code's basis provisions under section 1016 pertaining to improvements. Its analysis and the conclusion it reached are what have stirred up all the tax law commentators.

The Controversy
First, the court acknowledged that under section 1012 the initial basis in property acquired by purchase includes not only cash but "other property." And it conceded that other property includes personal liabilities of the purchaser and liabilities subject to which the property is taken under the Supreme Court's 1947 landmark decision in Crane (Crane, Beulah B. v. Commissioner, 331 US 1, 35 AFTR 776).

But then the court went on to explain that basis arising from later improvements to property is determined by looking to section 1016, which provides basis increases for "expenditures, receipts, losses or other items, properly chargeable to (a) capital account." It concluded that expenditures, receipts or losses surely do not include liabilities and could not fit "liabilities" of cash-basis taxpayers into the "other" item category.

Graciously, the court did conclude that when cash-basis taxpayers made note payments in subsequent years, they may increase their basis. The court did not, however, provide guidance about how to report later "basis adjustments" affecting gains and losses from an earlier disposition of the property. Nor did it advise what to do about depreciation of physical assets placed in service in earlier years but which obviously must not have been placed in service, since for tax purpose they did not exist until payment.

Surely, we now have a new brand of "tax nothing asset" to accompany "tax nothing entities" under the check-the-box entity classification regulations.

The Effect
Initially, what clearly caused all the trouble in the Owen case was that the promissory notes were issued to an entity the Owens controlled. Then they did not pay the notes. Finally, they attempted to add them to the tax basis years later.

But the decision becomes trouble for all taxpayers because it leads to a conclusion that when notes are given to an entity providing goods and services, no deduction is allowed until the notes are paid. The premise is that nothing changes when the notes are issued. That is, a cash-basis account payable is converted to a note to the same creditor and the offsetting deduction or capitalized amount is not recognized until payment takes place.

Just imagine the fun the creative types at IRS might have with the rationale underlying this decision.

Assume that Joe Sixpack trots down to the local Sears store and contracts a major overhaul of his pickup. Sears--having learned that lenders make all the money--hands him back the keys to the refurbished pickup and asks him to sign a promissory note.

Off Joe goes, with an overhauled pickup, complete with breezy new air conditioner. What Joe may not realize, however, is that this court--and an aggressive IRS--do not acknowledge the air conditioner's existence and will not let Joe capitalize its cost. Despite the fact that there is an air conditioner in Joe's car, and he owes Sears for it, the IRS and the court fail to "see" it.

On the other hand, if the Sears store arranged financing for Joe through the local bank or finance company, it would seem that Joe is entitled to "basis" in the asset under the same theory that applies to a deductible payment made by a cash-basis taxpayer with borrowed funds.

Rev. Ruls. 78-38 and 78-39 have long stood for the principle that cash-basis taxpayers can deduct expenses in the year in which they are charged to a credit card. There is in reality no reason why capital expenditures incurred in commercially viable transactions with unrelated parties (whether or not "direct") should be treated in the same fashion.

The Owen case typifies what happens when overzealous taxpayers go at loggerheads with the IRS; it also illustrates the risk associated with the IRS responding with various arguments and the court selecting a weaker one and misusing it. The Owen case concluded as it should have.

Bad facts. Add to that a District Court with perhaps a narrow and limited understanding of the federal tax law and the potential future ramifications of its analysis…and voila, we end up with a decision that might lead to a whole lot of unnecessary controversy between taxpayers the IRS. Right result, wrong approach. Yeah, Dad, I hear you.

One can hope that the Owen case will have limited application, and the IRS will--as a policy decision--not try to expand its scope based on the court's rationale. The Owen case was an effort to try to obtain a tax refund that the taxpayers took much too far. Practitioners should also note that all the bad things that Owen-type facts might lead to can be avoided with a little advance planning.