The Illegitimate "Earned" Requirement in Tax and Nontax Accounting.

Calvin H. Johnson*

There is a school of thought that believes that nontax financial accounting should lead

the tax system. Generally accepted accounting principles ("GAAP") are said to be

"scientific."1 Tax can depart from GAAP, it is said, only to prevent abuse, in the interest of

administrability or to provide taxpayers with special incentives. Absent such special

considerations, it is said, taxable income should be defined to follow the lead of nontax

accounting principles.2 Congress, it is said, intended that financial accounting principles

should be the "principle calculus" by which taxable income is computed.3

The most celebrated controversy is over not-yet-earned receipts or prepayments. Tax

accounting would include a prepayment in income when received, but nontax GAAP would

delay counting the prepayment as income until it is earned. Assume a core case, for instance,

involving a prepayment for services. Lawyer F receives $l million retainer from his client, Z

* Andrews & Kurth Centennial Professor of Law, University of Texas. The author thanks Professors Robert

Anthony, Joseph Dodge, Tom Evans, Mark Gergen, Daniel Halperin, Ira Shepard and participants in the

meeting of the Teaching Tax Committee, American Bar Association Tax Section in Houston, January 21, 1994

for helpful comments. The author thanks John Leamons for research assistance. 1 United States v. Anderson, 269 U.S. 422, 440 (1934) See also Harold Dubroff, M. Connie Cahill, Michael

Norris, Tax Accounting: The Relationship of Clear Reflection of Income to Generally Accepted Accounting

Principles, 47 ALBANY L. REV. 354, 404-405, 406 (1983) (tax should "resolve questions of the time of wealth

increases by reference to a body of learning developed for precisely that purpose by a large well-organized and

highly educated group of professionals."). 2 See, e.g. American Institute of Certified Public Accountants, Conformity of Tax and Financial Accounting

132 J. OF ACCOUNTANCY 75 (1971)(tax and accounting are based on common objective of fair determination of

business income on annual basis) and see commentary cited infra notes 16-27. 3 Brief for Amicus Curiae Chamber of Commerce in Thor Power Tool Co. v. Commissioner [439 U.S. 522

(1979), October Term, 1977, at 3, rejected by the Court, 439 U.S. at 540-544 (GAAP is not presumed binding

on tax because of differing objectives of tax and GAAP)..

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Inc., at the end of year 0 for consulting services to be performed over the next five years.

Lawyer F is a famous merger and acquisition specialist, a craftsman of takeover defenses and

someone you want in a storm. Z Inc is a potential target of a hostile takeover. Z Inc. will

consult with F from time to time about strategy and tactics. F will hold himself open for

consulting, earning the $l million payment by giving his time and advice over the five period.

F will also not give any aid or advice to a takeover shark that might consider Z Inc. to be a

vulnerable target. It is assumed in the core case that, under the law of F's jurisdiction, F may

commingle the $l million with the other funds that belong to him and use it for any purpose,

even before he earns it.4 Assume that F has earned none of his $l million when he receives it

and that he earns the retainer with his own personal services in equal segments each year for

five years.

The $1 million prepayment is intended to be entirely profit for F's services, although

not yet earned. A premise of the hypothetical is that there are no future costs properly

associated with the retainer.5 The contract might, for instance, provide that F will bill any

future costs, e.g., for associate or secretary time, zeroxing or travel, separately when and if

they occur. A major takeover defense is an expensive operation, much like an army

campaign, but the contract between F and Z Inc says that all those expenses will be covered

4 See, e.g., NY Ethical Opinion No. 570, (June 6, 1985)(refundable, unearned fees need not be kept in trust

account)(decided before amendment of disciplinary rules, with uncertain effect, providing that "funds belonging

lawyer or law firm may be withdrawn when due.)" N.Y. Code of Prof. Responsibility DR 9-102.B.4.

(1990)(emphasis added)); In re Stanton, 504 N.E.2d 1 (Ind. 1987)(per cur.)(trust requirements do not extend to

unearned but refundable amounts); In re Stern, 92 N.J. 611, 458 A.2d 1279, 1283 (1983)(in absence of explicit

agreement between client and lawyer, trust account need not be maintained for retainers). State law or ethical

mandates, however, sometimes do require that unearned refundable fees be placed in trust with the interest

thereon going to the client in case the fees are never earned. See, e.g., Tex. ETHICS Op. 391, 41 TEX. B. J. 322,

323 (1978)(unearned legal fee must be placed in trust). For a short discussion of entrusted funds, in other

hypotheticals, see infra notes 50-51 and accompanying text. 5 For a discussion of the tax issues arising from future costs, infra note 56.

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separately should they arise. The $l million is only for F's time, advice and loyalty over the

next five years.6

Under nontax accounting principles, "[r]evenue is not recognized until earned"7 If tax

followed GAAP, F would have no taxable income upon receipt of the million dollars, but

instead would have income of $200,000 per year in the following five years.

Under tax law, by contrast, F would have taxable income of one million dollars

immediately upon receipt, because of a trilogy of Supreme Court cases.8 There is a bit of

wiggle room under the trilogy because the Court's rationales for denying deferral were

procedural and skirted the substantive merits of the issue. The Court said that it was just

6 A baseball or football star getting a signing bonus and a best-selling novelist getting an advance on her next

book are like F in that they receive substantial prepayments in consideration for future services but can not

expect to have substantial future costs associated with the revenue. 7 Financial Accounting Standards Board (hereinafter "FASB"), Statement of Financial Accounting Concepts

No. 5, Recognition and Measurement of in Financial Statements of Business Enterprises. ¶84 (1984). See also

FASB, Statement of Financial Accounting Concepts No. 3, Elements of Financial Statements of Business

Enterprises, ¶31 (1980)(liabilities defined to include obligation to provide future goods and services), ¶¶81-82

prepayments are deferred when received and recognized as income over time, ¶129 (unearned revenue are

liabilities because the enterprise must provide goods or services a later time). See, e.g., Donald E. Kieso & Jerry

J. Wygandt, INTERMEDIATE ACCOUNTING 73-74 (4th ed. 1983). 8 Schulde v. Commissioner, 372 U.S. 128, 134 (1963)(prepayments for dance lessons taxable when received);

American Automobile Association v. United States, 367 U.S. 687, 691-692 (1961)(statistics of average monthly

costs were not sufficient to justify deferral of revenue); Automobile Club of Michigan v. Commissioner, 353

U.S. 180 (1957)(Commissioner did not abuse discretion in requiring immediate inclusion of prepaid dues,

where taxpayer's method of proration was purely arbitrary).

The 1954 Code, as enacted initially, allowed deferral of prepayments for up to five years, but in 1955

Congress repealed the section retroactively because it was too expensive, at least in transition. IRC of 1954,

§452, repealed by Act of June 15, 1955, ch. 143, 69 Stat. 134. H.R. REP. NO. 372, 84th Cong., 1st Sess. 5

(1955).

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deferring to IRS discretion exercised under a broad grant of authority,9 and that taxpayer had

just failed sufficiently to prove the actual time of future performance.10 Still, the standard the

taxpayer must pass for deferral is said to be unforgiving because "tax accounting can give no

quarter to uncertainty"11 and the trilogy is also said to rest on the "sweeping ground" that the

taxpayer may not defer income to a later period.12 In any event, the cases since the trilogy

deny deferral of taxation beyond receipt, either as a flat prohibition or under the

circumstances of the case,13 with the exception of two or three sports.14 As a practical

9 IRC §446(b). See, e.g., Reed Shuldiner, A General Approach to the Taxation of Financial Instruments, 71

TEX. L. REV. 243, 295 n. 231 (1992)(reading the trilogy as merely giving the Commissioner wide latitude to

make administrative decisions) 10 See, e.g., Laurie Malman, Treatment of Prepaid Income-- Clear Reflection of Income or Muddied Waters,

37 TAX L. REV. 103 (1981)(deferral should be allowed under current law where contract, statistics or facts and

circumstances give reasonable assurance of future performance) 11 RCA Corp. v. United States, 664 F.2d 881, 888 (2d Cir. 1981) cert. denied 457 U.S. 1133 (1982) (receipts

attributable to costs of service under warranty) citing Thor Power Tool Co. 439 U.S. 522, 543 (1979). 12 Cox v. Commissioner, 43 T.C. 448, 455 (1964). 13 See, e.g., RCA Corp. v. United States, 664 F.2d 881 cert. denied 457 U.S. 1133 (1982); Allied Fidelity

Corp. v. Commissioner, 572 F.2d 1190 (7th Cir. 1978) cert. denied, 439 U.S. 835 (1978); Mutual Life

Insurance Company v. United States, 570 F.2d 382 (1st Cir. 1978) cert. denied 439 U.S. 821 (1978)(interest

paid in advance); Est. of Stranahan v. Commissioner, 475 F.2d 867 (6th Cir. 1973)(prepaid dividend included,

at taxpayer's bequest); Hagen Advertising Displays, Inc. v. Commissioner, 407 F.2d 1105, 1107 (6th Cir. 1969);

Van Wagoner v. United States, 368 F.2d 95, 97-98 (5th Cir. 1966)(Life insurance commissions); Signal Baking

Corp. v. Commissioner, 106 T.C. No. 5 (1996)(nonrefunable credit card fees must be taken into income

immediately when received; refundable fees are different); T.F.H. Publications Inc. v. Commissioner, 72 T.C.

623, 643 (1979)(while rule of nondeferral is not absolute, deferral not allowed when period of performance is

not certain); Standard Television Tube Corp. v. Commissioner, 64 T.C. 238 (1975); BJR Corp. v.

Commissioner, 67 T.C. 111, 123 (1976)(now firmly established that advance rents are taxed when received);

Decision, Inc. v. Commissioner, 47 T.C. 58, 62 (1966); William O. MacMahon, Inc. v. Commissioner, 45 T.C.

221, 230 (1965); Bell Electric Co. v. Commissioner, 45 T.C. 158, 166 (1965)(trilogy prevents excluding

amounts actually received); Farrar v. Commissioner, 44 T.C. 189 (1965)(prepayments under men's suit club

may not be deferred); Cox v. Commissioner, 43 T.C. 448, 455 (1964); Popular Library, Inc. v,. Commissioner,

39 T.C. 1092, 1099 (1963)(prepaid subscription income for services to be performed at future fixed date); New

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matter, the IRS has given away a significant fraction of its court victories by itself allowing

tax deferrals for various prepayments.15 The IRS sanctioned deferrals, however, do not cover

F's case.

The critics over 50 years have been loud and hostile to immediate taxation, favoring

deferral instead. Immediate tax has been said to be a "strange" interpretation, and a "strained,

awkward, and difficult" departure from GAAP, made by "men, no doubt eminent in their own

fields, but almost entirely innocent of any technical accounting knowledge."16 Immediate tax

is said to be a "misapplication of accounting concepts,"17 a "hybrid" accounting method, half

Capital Hotel, Inc. v. Commissioner, 28 T.C. 706,708 (1957)(prepaid rent); Andrews v. Commissioner, 23 T.C.

1026, 1033 (1955)(GAAP must bow to claim-of -right doctrine); Bell Federal Savings and Loan Assoc. v.

Commissioner, 62 T.C.M. 376 (1991)(prepaid interest taxed to lender immediately); Handy Andy TV

Appliance v. Commissioner, 47 T.C.M. 478 (1983)(warranty costs): Wide Acres Rest Home, Inc. v.

Commissioner, 26 T.C.M. 391 (1967); Heubner v. Commissioner, 25 T.C. M. 406 (1966)(lawyer's fees were

held under claim of right); Treas. Reg. §1.61-8(b)(1957)(prepaid rent). 14 Boise Cascade Corp. v. United States, 530 F.2d 1367 (Ct. C. 1976)(contractual obligations to perform future

services were fixed and definite so to allow taxpayer to avoid a "hybrid system combining elements of the

accrual system with a cash system, a mixture generally viewed with disfavor."); Artnell Co. v. Commissioner,

400 F.2d 981 (7th Cir. 1968)(advanced ticket sales were not income until the baseball game was played):

Barnett Banks of Florida, Inc. v. Commissioner, 106 T.C. No. 4 (1996)(refundable credit card fees may be

taken into income pro-rata over 12 months): Collegiate Cap & Gown, 37 T.C. Mem. 960 (1978)(deferring to

Artnell but only for taxpayers from the 7th Circuit). Cf. Morgan Guaranty Trust Co. of N.Y. v. United States,

585 F.2d 988, 997(Ct Cl. 1978)(allowing deferral but emphasizing deferred amount is immaterial). 15 IRS Notice 89-21, 1989-1 C.B. 651(upfront receipt from a swap contract deferred to be income over the life

of the contract); Rev. Proc. 71-21, 1971-2 C.B. 549 (prepaid service income may be deferred to following year

if all the services must be performed within that year); Treas. Reg. §1.451-5 (1971)(deferral on prepayments for

goods and multi-year contracts for up to two years). But see, Treas. Reg. §1.61-8(b)(1957)(advance rentals

taxed when received regardless of period covered or the method accounting); Rev. Proc. 92-98, 1992-2 C.B.

512, 514 (multi-year warranty receipt may be deferred, when taxpayer covers cost with capitalized insurance,

but only if the taxpayer imputes interest income that compensates for the deferral). 16 Lasser & Peloubet, Tax Accounting Versus Commercial Accounting, 4 TAX L. REV. 343, 347 (1949) 17 Robert Behren, Shulde Holds Prepaid Income Taxable on "Receipt": Rationale is Uncertain, 18 J. TAX'N

194 (1963).

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cash and half accrual, which "distorts income"18 and is "satisfactory to no one."19 The IRS, it

is said, should stop "harassing" taxpayers by applying cash method concepts to receipts by

accrual taxpayers.20 Unearned receipts are said not even to be "income" within the meaning

of the Sixteenth Amendment, and so should not be taxable as a Constitutional matter.21 Tax

law, it is said, should restore the proper correlation between tax and GAAP22 and "resolve

questions of the time of wealth increases by reference to a body of learning developed for

precisely that purpose by a large well-organized and highly educated group of

professionals."23 In 1947, one critic regretted the tax law's distortion of sound accounting

over the then "last 25 years."24 Forty-five years later the criticism is the same.25 Even anti-

loophole reformers criticize the trilogy as not clearly reflecting income, in cases in which the

18 S. Ralph Jacobs, Changing Attitudes Toward Accrual Concepts, 16th N.Y.U. TAX INST. 579, 586, 597

(1958) 19 Abraham Stanger, Henry Vader Kam & Pearl Polifka, Prepaid Income and Estimated Expenses: Financial

Accounting Versus Tax Accounting Dichotomy, 33 TAX LAWYER 403, 426 (1980). 20 Daniel Weary, IRS Creation of Hybrid Methods: Prepayments and the Cash Method; Prepayments and the

Accrual Method, 35th N.Y.U. TAX INST. 59, 76 (1977) 21 John Nolan, The Merit In Conformity of Tax to Financial Accounting, 50 TAXES 761, 768-69 (1972). 22 Robert Aland, Prepaid Income and Estimated Future Expenses: Is a Legislative Solution Needed?, 54

A.B.A.J. 84, 89 (1968) 23 Harold Dubroff, M. Connie Cahill, Michael Norris, supra note 1, 47 Albany L. Rev. 354, 404-405, 406

(1983) 24 Chester Edelman, Is Income Tax Accounting "Good" Accounting Practice?, 26 TAXES 113, 121-122 (1946) 25 William Raby, Meaning of 'Accrued' -- Accounting Concepts Versus Tax Concepts, 57 TAX NOTES 777

(NOV. 9, 1992)(aligning financial concepts of income and tax concepts would be "marvelous" and simplifying);

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taxpayer might get some advantage from immediate tax.26 The critics' hostility is consistent

over a long period of time.27

It is the conclusion of this article that GAAP and the critics of the tax rule are wrong on

the merits. The "earned" requirement is illegitimate for both tax and nontax accounting. A

prepayment represents an immediate improvement to the net worth of the recipient.

Deferring not-yet earned profits until the profits are earned understates the net present value

of the receipts and the contribution the profits to the taxpayer's wealth and standard of living.

26 LeeSheppard, Equipment Leasing Shelters for Corporate Customers. 66 TAX NOTES 1591 (1994)(arguing

that "clear reflection" requirement of IRS §446(b) can be invoked by the Commissioner to prevent corporation

from taking big lump income in year net operating losses would expire.) 27 See also Robert Scarborough, Payments in Advance of Performance, 69 TAXES 799, 809, 818

(1989)(recepient in effect pays tax on investment income before performance, whereas payor should pay tax on

interem income); Harold Dubroff, The Claim of Right Doctrine, 40 TAX. L. REV. 729, 732 (1985); Dave

Stewart & R.Glen Woods, Analysis of the Trend Toward Deferring Recognition of Prepaid Income, 59 TAXES

400 (1981)(proposing statutory amendment under which taxpayer would not pay tax on receipts until they are

earned); Johannes Krahmer, Taxation of Advance Receipts for Future Services, 1961 DUKE L. J. 230, 258

(statute and "sound accounting" require deferral); Robert Behren, Prepaid Income- Accounting Concepts and

the Tax Law, 15 TAX L. REV. 343 (1960)("distorted misapplication "of claim of right doctrine so as to tax

receipts which have not been earned); William Emery, Time for Accrual of Income and Expenses, 17th N.Y.U.

INST. TAX 183 (1959)(income tax accounting can not be dissociated from GAAP); Donald Shapiro, Tax

Accounting for Prepaid Income and Reserves for Future Expenses, 2 COMPENDIUM OF PAPERS ON BROADENING

THE TAX BASE SUBMITTED TO COMM. ON WAYS AND MEANS, 86th Cong., 1st. Sess. 1133, 1141, 1152

(1959)(while recognizing that immediate tax avoids judgments and estimates and produces a more uniform

result among taxpayers, ultimately recommends legislation allowing deferral); Murray Rothaus, A Critical

Analysis of the Tax Treatment of Prepaid Income, 16 MARYLAND L. REV. 121(1957)(immediate tax is legally

unjustified); James Heffern, Claim-of-right and Other Tax Doctrines are Distorting Proper Accounting, 5 J. OF

TAX'N 29 (1956); George O. May, Accounting and the Accountant in the Administration of Income Taxation,

47 COLUM. L. REV. 377, 389 (1947)(payment in advance for goods or services is not intended to be income

under revenue statutes); AICPA, CONTEMPORARY ACCOUNTING: A REFRESHER COURSE FOR PUBLIC

ACCOUNTANTS 2-17 (Arthur Leland, ed. 1945)(advanced payments are loans from customers offset by a

liability). But see, J. Dodge, THE LOGIC OF TAX 207-209 (1989)

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Deferring the taxable event adds complexity that obscures the simple economic truth of an

immediate improvement in net worth. Deferring taxation until the receipt is earned is bad

economics, bad accounting and bad tax law, even if we known when the future services will

be performed.

I. Bad Economics

A. Time Blindness.

GAAP standards for accounting for unearned receipts misstates the net present value of

the unearned receipts. Firm F in our hypothetical in fact had $l million immediately. GAAP

reports F's net income as if F were exactly like a firm that had only $200,000 income per year

over the following five years. GAAP's transformation , shown with cash flow diagrams, is that

:

$l million $200,000 $200,000 $200,000 $200,000 $200,000

becomes •___ ___ ___ ____ ____

year 0 1 2 3 4 5

___•____•_____•_____•____•

year 0 1 2 3 4 5

The transformation GAAP makes misdescribes the value of the transaction to F. A

$1 million receipt has a present value when received of $1 million. The $l million dollars is

the only compensation that F will get from the transaction and, simply stated, the $l million

receipt is the only economic event we need to know about. The $l million improves F's

wealth immediately. If we view F as a firm or an investment, then F's firm is like a bank

account in the amount of $l million. F could withdraw $l million immediately and if F kept

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the $l million invested in the firm, the firm would make interest on the full $l million. Doing

anything other than taxing F immediately is a complexity that obscures the simple $l million

nature of the transaction.

Under GAAP, by contrast, firm A is reported as if it had $200,000 receipts over the

next five years. If we assume 10% interest rates (assumed throughout for simplicity), the net

present value of $200,000 over 5 years is only $758,000.28 F's firm is like a bank account of

only $758,000 because withdrawals of $200,000 from a bank account earning 10% interest

over the next five years would deplete the account at the end of five years.29

GAAP misdescribes not only the net present value of the transaction to F, but also the

income that F could be expected to earn in the coming years. Under the assumed 10%

interest rate, a firm with a net worth of $l million could be expected to generate $100,000

annual interest-like income indefinitely. As reported, however, F has no net worth to

generate interest immediately and thus should be expected to generate no interest. Even if

we see the future compensation, F will get, the net present value derived from the transaction

is only $758,000, which would imply only $75,800 income per year indefinitely. In fact, F

with $ l million investable funds and no offsetting costs can be expected to make the

28 The formula for the present value of an annuity of amount A per year is A[1-(1+i)-n]/i. With A or

$200,000, n of 5 and i of 10%, the present value is $758,157. . 29 The following table shows the withdrawals of $200,000 that deplete a $758,000 account over five years:

1. 2. 3. 4. 5.

year starting account

balance

interest (10%

of 2.

withdrawal new balance

(2.+3.-4.)

1 $758,157 $75,816 $200,000 $633,973

2 633,973 63,397 200,000 497,370

3 497,370 49,737 200,000 347,107

4 347,107 34,711 200,000 181,818

5 181,818 18,182 200,000 0

The table is confirmation of the accuracy of the annuity formula, supra note 28, by which the $758,000 present

value was calculated.

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$100,000 interest per year, if it kept its earnings invested (but no compounding interest), just

as immediate income would imply.

The GAAP error is material. A material error is one large enough for users of the

information to be influenced by it in their decisions.30 The GAAP description of F is off by

a quarter of F's value, enough to make a difference in almost all investor decisions. Even

fairly sophisticated investors could be expected to be mislead.31

The Financial Accounting Standards Board describes the function of financial

accounting as being to disclose information to investors and creditors of the firm relevant to

the determination of the value of future cash flows of the firm.32 GAAP misdescribes the true

present value of the cash inflows to F. To be useful to investors, standards of financial

accounting have to be consistent with the theory by which investment decisions are made.

When the International Bureau for Weights and Measures sets a standard for the length of a

meter or the definition of horsepower, for instance, the standards have to be both useful and

consistent with current theory.33 We would not want the official chemical standards, for

30 FASB, Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting

Information, ¶123 (1980). 31 The working assumption of even sophisticated investors is that the accounting figure, "retained earnings," is

an investment amount generating future returns. Pogue & Lall, Corporate Finance: An Overview in S. Myers,

MODERN DEVELOPMENTS IN FINANCIAL MANAGEMENT at 33-34 (1976). See also discussion in text

accompanying infra notes 84-85 (deferral is misleading about future investment income).

32 FASB, Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business

Enterprises ¶37 (1977)("financial reporting should provide information to help investors, creditors and others

assess the amounts, timing and uncertainty of prospective net cash inflows to the ... enterprise."). Accord

Laurie L. Malman, supra note 10, 37 TAX L. REV. 103, 104, 105 (1981)(arguing for deferral because

accounting should describe net worth). 33 See, e.g., Malcolm Browne, Yardsticks Almost Vanish as Science Seeks Precision, N.Y. TIMES, Aug. 23,

1993, 1 (describing evolution in standards for the meter and the horsepower). See also Rexmond C. Cochrane,

MEASURES FOR PROGRESS (1966)(describing the role of the National Bureau of Standards in helping scientific

progress).

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example, to be measuring phlogiston released by combustion, two hundred years after

oxygenation has replaced phlogistics as the theory we use to explain combustion.34 On the

most basic level, however, GAAP standards on unearned income are inconsistent with the

current theory of investing. GAAP has flunked elementary time value of money.

The GAAP error on prepayments is not an isolated mistake. Traditional accounting

was almost entirely blind to the time value of money and accounting standards are being

corrected only incrementally. Nontax accounting has been guided by the principle of

"matching." Under matching, the real timing of cost or revenues are ignored and are

recognized earlier than cash receipt or payment ("accrued") or recognized later than actual

receipt or payment ("deferred"), so that related costs and revenues can all be reported in the

same time period.35 The difficulty is that "matching" slides payments up and back along a

time line, fully innocent of the fact that changing the time amounts are considered to be paid

or received changes the value of the payments or receipts.36

GAAP has made some headway in reflecting the time value of money. Fixed

receivables or payables, for example, must now be discounted so that only their present value

is reflected in the current accounts, if the payments are expected to be delayed for more than

a year after the reporting date.37 In 1993 the Financial Accounting Standards Board required

banks and Savings and Loan Associations to measure their losses from impaired loans by 34 Thomas Kuhn, THE STRUCTURE OF SCIENTIFIC REVOLUTIONS 52-56 (2d ed. enlarged 1970)(describing the

"discovery" of oxygen with emphasis on the reconceptualization of combustion). 35 See, e.g., De Caprilles, Modern Financial Accounting, Part 1, 37 N.Y.U. L. REV. 1001, 1015-1018

(1962)(fundamental importance of matching). 36 See Calvin Johnson Silk Purses from a Sow's Ear: Cost Free Liabilities Under the Income Tax, 3 AMER. J.

OF TAX POLICY 231, 283-284 (1984)(arguing that time value considerations are going to force abandonment

of matching). 37 Accounting Principles Board, Opinion No. 21, INTEREST ON RECEIVABLES AND PAYABLES (1971). Opinion

No. 21 is weaker in operation than on paper because auditors can not always tell how long the payment will be

deferred when the accounting books are closed, except by looking at the terms of the obligation. Thus delays

that are not described by the instrument itself will rarely be reflected in the discounting.

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looking to the present value of the expected future cash from the loan after the

restructuring.38 The prior rule, which had ignored the bank's losses by ignoring the time

value of restructured loans, had been an embarrassment.39 The prior rule contributed not

insignificantly to the multi-hundred billion losses suffered by the Savings and Loans

Associations, by sweeping the problem of heavy real S&L losses under the rug.40 As the

standards board comes to grips with the requirements of time value, we should expect further

changes.

For now, however, GAAP continues much of its traditional time blindness. GAAP

standards, for example, ignore time value in taking account of long distant future unfixed

expenses, such as clean up costs for strip mining or nuclear power plants.41 GAAP treats

38 FASB, Financial Accounting Standards No. 114, Accounting for Creditors for Impairment of a Loan ¶13

(1993). The new standard, however, bends in favor of the banks and S&L's by allowing the creditor to use the

old negotiated interest rate to appraise discounted present value, even when risks and prevailing interest rates

have significantly risen. 39 Under the now superseded standard, a troubled S&L Association would recognize no loss even if it forgave

all future interest and extended the loan, unless the total undiscounted future cash to be paid on the loan, after

the restructuring, is less than the book value of the debt. FASB, Financial Accounting Standard No. 15,

Accounting for Debtors and Creditors for Troubled Debt Restructurings (1977). Under that standard, an S&L

could lose most of the value of a loan without recognizing any loss. Assume, for instance, a troubled debtor has

a fully current $l million liability due in five years and bearing fair market value 10% interest. The debtor

returns to the S&L and after negotiation, the S&L and the debtor end all future interest and delay payment of

principal for 30 years. With a 10% discount rate, the S&L's asset has dropped from value of $1 million to

discounted present value of $1 mil/(1+10%)30 or $57,308., but the bargained change in value would have no

impact on the S&L under GAAP. See criticism, e.g., by D. Kieso & H. Wygandt, INTERMEDIATE ACCOUNTING

632 (4TH ED. 1983)(" unsound accounting") The new standard, effective beginning in 1995, requires the

creditor to measure loss based on the discounted present value of expected future cash flow from the loan. 40 For a fine, short description of the causes of the S&L crisis, see Robert Liton, Savings and Loan Crisis, in 3

NEW PALGAVE DICTIONARY OF MONEY & FINANCE (1992) 41 FASB, Emerging Issues Task Force, Minutes of Open Meeting, May 20 ,1993 (Lexis electronic

edition)(environmental clean-up liabilities may be discounted to reflect time value only if the aggregate amount

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remotely possible future taxes as if they were already-paid tax expenses42 and GAAP, of

course, defers recognition of unearned receipts.

It is possible to achieve matching and give the taxpayer deferral, without granting any

economic benefit from the deferral, by charging interest on tax due. The taxpayer could be

treated as if he had an immediate obligation to pay tax on the receipt of the $l million and if

the tax is delayed until the $l million is earned over the five years, or for that matter to any

time after receipt, then the taxpayer would be charged interest on the tax due for the time

between the receipt of the prepayment and the time tax on it is collected. If the interest were

high enough to cover both credit risks and time-value of money, then the deferral would not

reduce the net present value of the taxpayer's tax payments.43 There does not, however, seem

to be any good reason to make the government a mere creditor of the taxpayer if the tax is

properly due upon receipt, given the government's need for revenue. The taxpayer has cash

that could well be used to pay the tax and there is no good reason to expose the government

to the credit risks of the taxpayer. The argument over the earned requirement, in any event,

is about what the present value of the tax should be, so that deferring income without

improving the taxpayer's tax burden, stated in time-value terms, misses the point.

and timing of the cash payments is fixed or reasonably determinable). Deducting undiscounted liabilities is

criticized in Calvin Johnson, supra note 36. 42 FASB, Financial Accounting Standards No. 109, Accounting for Income Taxes ¶198 (standards will not

require discounting of future taxes to compute tax expense). For a debate on the appropriate remedy, compare

J. Alex Milburn, Comprehensive Tax Allocation: Lets Stop Taking Some Misconceptions for Granted,

CAMAGAZINE 40 (April 1982)(discount future tax payments) with Christina Drummond & Seymour Wigle,

Let's Stop Taking Comprehensive Tax Allocation for Granted, CAMAGAZINE 56 (OCT 1981)(do not debit

expenses for deferred tax payments at all unless account is likely to reverse as a whole in foreseeable future). 43 See, e.g, Rev. Proc. 92-98, 1992-2 C.B. (receipt for multi-year warranty may be excluded under certain

circumstances, but only if the taxpayer imputes interest income to compensate for the deferral). Cf. IRC 453A

(charging interest on tax deferred by installment method in some circumstances). See Christopher Hanna, The

Virtual Reality of Eliminating Tax Deferral, 12 AM. J. OF TAX POLICY -- (1995)(interest can be used in a

number of circumstances including unearned receipts to compensate for deferral).

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B. The Untenable Liability Rationale

The most common rationale given to explain why prepayments are not treated as

income under financial accounting is that the cash received is offset by a liability to the

customer.44 The double-entry-bookkeeping accounts do not deny that F has received $l

million cash in year 0. There is a $ l million debit to cash in F's journal upon receipt to

reflect that F's cash assets are increased by the $l million. The increased cash is not

allowed to be considered income or improvement in net worth, however, because the

credit in year 0 is not to income or net worth, but to "deferred revenue." "Deferred-

revenue" is a quasi-liability account, listed on the right side of balance sheet below other

liabilities, but above the line where accumulated earnings and other net-worth-improving

accounts are listed. The function of "deferred revenue" account is to prevent a credit to

F's income and net worth until the cash is earned.

As the firm earns its prepayments, the cash is released from the suspension in the

anti-income block of "deferred revenue." Each year, there is a $200,000 decrease (debit)

to F's deferred revenue account and an increase (credit) to F's current income. At year

end, the year's income is closed to accumulated earnings, which is part of net worth. By

the end of the 5 years, the whole $l million would have been transferred out of the

deferred income account and into income and net worth.45

44 FASB, Statement of Financial Accounting Concepts No. 3, Elements of Financial Statements of Business

Enterprises, ¶31 (1980). Accord, W. Paton and A. Littleton, AN INTRODUCTION TO CORPORATE

ACCOUNTING STANDARDS 59 (1940)(funds deposited are fully covered by the obligation to the customer

until goods or services are proved because in the event that the vendor is unable to make delivery the entire

amount must be returned.); W. Paton and R. Dixon, ESSENTIALS OF ACCOUNTING 211 (1958)(all

prepayments a customer extending credit to vendor). See also AICPA, supra note 27, 2-17 (Arthur Leland, ed.

1945)(Defending deferral for tax purposes, arguing that if accounting had just designated amounts received

prior to performance as advance by customers and included the items in current liabilities where they belong, it

is barely possible that Treasury would even have challenged). 45 . See, e.g., Donald E. Kieso & Jerry J. Wygandt, supra note 7 at 73.

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The accounting treats a firm receiving prepayments as if it had borrowed cash from

its customer. Borrowed cash is properly considered neither income nor improvement to

net worth. Cash borrowing leaves the borrower with an obligation to repay that can be

expected to offset the value of the borrowed cash completely. Banks and other creditors

lending cash protect their net worth in the lending by charging interest. Creditors charge

interest that is high enough to ensure that the lending is not expected to drop their net

worth, even when credit risks and other money making opportunities are taken into

account. Because lenders are largely successful in making sure the obligation to repay is

at least as valuable as the cash lent, we can reasonably presume that the borrower has no

improvement in net worth by borrowing.46

A firm that receives a prepayment, however, does not have an obligation anything

like that on a cash loan merely because it has not yet earned the money. Unearned profits

of $l million can be expected to increase F's present-value worth by $l million

immediately. Lawyer F does have an obligation to give services or other consideration in

the future, but the consideration given for profit does not offset profit. Cash offsets that

do count can be expected to have quite modest value.

1. Services can not offset cash.

The most important obligation F has undertaken in exchange for the $l million is to

provide consulting services. It can be assumed from the bargaining between F and his

client, that F is expected to perform future services or give loyalty by forbearing from

giving aid to some enemy and between the two F will give consideration that is worth the

$l million cash.

46 Graetz, FEDERAL INCOME TAXATION: PRINCIPLES AND POLICIES 216 (2d Ed. 1988)(borrowing is

not taxed because borrowed amounts offset by obligation). Cf. Boris Bittker, 3 FEDERAL TAXATION OF

INCOME ESTATES AND GIFTS 85-36 (1981)(tax law gives advanced credit for an obligation to repay, just a

lender gives borrower advanced credit for the obligation.) See IRC. §7872(b)(borrowed proceeds will be an

income item if not offset by discounted present value of obligation to repay).

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The services or other consideration that F gives back to client can not, however,

count as an offset to compensation received nor as a recognizable obligation to repay. If

services offset compensation, then no firm could ever have compensation income: Its

compensation would always be offset and zeroed out by the value of the services it gave

back in return. Even earned amounts would not be income if services offset income: the

debit from compensation revenue would always be netted to zero by a credit arising from

the services given back.

Treating services as an offset to receipts is thus not just a timing error, but a graver

error of giving respect to items that can not treated as a cost at any time. Whether the

services are future services, past services or services performed simultaneously with

payment, the services can not count as an offset against reported compensation.

Counting services to be performed in the future as if they were a "liability" offsetting

cash received is not tenable.47

More generally, any business firm making a profit gives consideration to its

customers from whom the profit was derived and the consideration can be expected to

have a value equal to the amount of the profits. Without the consideration, the customers

of the firm would not have voluntarily given the business the money that makes up its

profit. Still, the consideration given for profit can never be used to offset profit because

it did no firm would ever have profit. Thus when a middleman seller of goods receives a

47 In tax accounting language, we can say that F gets no exclusion with respect to the $l million cash receipt,

because F has no basis and will get no basis for the services. F does not pay tax when the services arise and

without paying tax, F gets no basis. The function of basis is to prevent a second tax on amounts already taxed

and without the tax, there is no offset. Thus a cash taxpayer who is not paid interest that has been accrued can

not get a tax loss for the never-received interest. See, e.g., Collins v. Comm'r., 1 B.T.A. 305, 308

(1925)(denying a cash method taxpayer a deduction when accrued interest was never in fact received). The

nontaxation in the first place is a full and adequate remedy for the nonreceipt. So too, the taxpayer who

performs services can get no deduction or exclusion ever for the services. The services are not taxed when they

arise and they can not be used to produce deduction or exclusion when they are used.

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prepayment, the profit element of the prepayment needs to be taxed immediately,

notwithstanding that the middleman gives back value to earn his profit. Whether

prepayment is for goods or services, the consideration for the profit element can not be

used to offset cash and cause the cash to be a loan.

2. Role of the interest factor.

There is undoubtedly an interest factor built into F's services by the bargaining

between F and the client, but interest does not change the argument. F's can be expected

to give services of more than $l million, looking at the services at the time they are

performed by enough to pay interest on the $l million. By paying early, Z Inc. gave up

the opportunity to make interest on the $l million and F got the opportunity to make the

interest. In a commercial bargain at arm's length, one party, client Z Inc., does not give

up something of value, such as the opportunity to make interest, unless the party gets

back something, here services, worth at least the opportunity given up.

The extra services for interest supports the argument that F has a $l million

improvement in value immediately when the unearned payments are received. To say

that Firm A will provide services worth $l million plus interest in a fair bargain is just

another way of saying that the services will have a net present value of $l million at year

0. Client, Z Inc., gave F only one payment, $l million. Under the barter equation both

the compensation and the profits can be expected to equal $l million.

While F will pay interest with extra services, services can not count as a cost to F.

Services can not count as a payment of interest for same reason that services can not

offset the $l million cash received at the outset. F has zero basis in his services. If

services counted as a deduction or exclusion or cognizable cost, then no one would ever

have compensation or net income from services.

Indeed, the interest factor, reflected in present-value discount, explains why GAAP

misdescribes F's situation. GAAP treats F as like a firm receiving cash in each of the

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five following years and such cash would have discounted present value in year zero of

$758,000. The services expected from F must thus have be assumed to be worth

$758,000. The true barter between F and Z Inc. was for cash compensation and services,

both of which were expected to be worth $ l million.

It is also the interest factor that F gets that helps distinguish F's unearned receipt

from a borrowing. A firm borrowing $l million when prevailing interest rates are at 10%

would have to turn over $100,000 in cash to the lender to cover the interest.48 The

borrower could keep investment returns only to the extent it exceeded $100,000. The

prepayment is different from a borrowing because F keeps the $100,000 interest and does

not have to pay it over to anyone else.

3. Interest-free loan?

GAAP, it can be argued, assumes that F gets to keep the annual $100,000 interest

form investing $l million because his client has lent him the $ l million, interest-free.

The deferred revenue account, on the liability side of the balance sheet, blocks the cash

asset of $ l million from increasing net worth until earned, but the deferred revenue

liability account does not bear interest and thus does not block the subsequent investment

return from being considered F's income. Thus in subsequent years, F's gross interest

return of $100,000 has no offsetting interest expense, so that F's $100,000 gross

investment return is the same as F's net income. We are asked by GAAP to believe that

F makes his $100,000 net investment return per year because client, Z Inc., did not

charge interest.

Interest-free loans, however, are not a very satisfying explanation for commercial

transactions between F and his client because real lenders do not give interest-free loans.

48 The possibility that a lender might allow the interest to accrue and compound does not change the reasoning

in text. By charging compound interest on the interest, the borrower will get a present value of $100,000 as if

the borrower had paid the $100,000 interest and the lender had then lent it back.

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As noted, the client gave up the opportunity to make interest of $100,000 per year and F

has the opportunity and commercial parties do not give up such opportunities free. There

is no such thing as an interest-free loan. Arm's length bargainers do not allow and it is

possible to think about of an interest-free loan only within the context of blindness as to

the time value of money. If the interest was not stated, it is not because the interest was

not there but simply because the parties did not disclose it.49 If GAAP uses an interest-

free loan as a justification for its treatment, GAAP is not appealing to a real life

transaction that a prepayment is like; it is using an artificial transaction -- imaginary as a

unicorn -- as a make-weight to express a conclusion. Characterizing the prepayment as a

an interest-free loan carries no independent weight.

4. Trust fund?

A firm receiving a prepayment from a customer is also said not to have income

from a prepayment because the firm stands in "a fiduciary relationship with respect to the

funds received" until the services are performed.50 The "fiduciary" relationship argument

is pure make-weight, however, because F's economic position with respect to the

unearned receipt is not anything like that of a trust fiduciary. A trustee may not list trust

funds as an asset on its own balance sheet, he may not commingle entrusted funds with

his own, and he certainly may not the keep the income from the entrusted funds. In the

hypothetical, F will be able to treat the $l million as his own asset commingled with other

assets, F can do anything he wants with the $l million, and F will keep the $100,000 per

year that the $l million prepaid funds will generate.

49 See, e.g., STAFF OF JT COMM. ON TAXATION, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE

TAX REFORM ACT OF 1984 526 (1985)(explaining the enactment of IRC §7872 by saying "a below-market loan

is the economic equivalent of a loan bearing a market rate of interest and a payment by the lend to the borrower

to fund the payment of interest by the borrower.") 50 W. Paton and R. Dixon, ESSENTIALS OF ACCOUNTING 211 (1958)

-20-20

Trust funds do not improve the trustee's net worth or income. If F had to keep the

$l million retainer in a segregated trust account and turn over the $100,000 annual

income from that account to the client, then F would be a trustee and the client would be

the taxable owner.51 The difference between trust funds and unearned receipts is between

F's holding funds for someone else and F's having its own money. The prepayment in the

hypothetical is F's own money, improving his net worth immediately.

5. Refunds.

While services are F's most important obligation to his client, F also plausibly will

have an obligation to refund the $l million to the client if he is unable to perform services

bargained for by the parties. The "liability" that blocks the prepaid $l million from being

booked as income is sometimes said to be an obligation to provide goods or services or to

"refund the cash."52

An obligation to refund cash in the future does reduce present value or net worth,

much as a obligation to repay a debt in the future reduces present value. A refund is cash

and counts where services or other consideration given for profit do not. Refunds reduce

current net worth, however, only at their discounted present value, considering both a

51 See, e.g., Clem H. Block v. Commissioner, T.C. Memo 1972-130 aff'd on other issues 482 F.2d 1342 (6th

Cir. 1973)(per curiam)(client funds held by a lawyer in a trust account are properly not income to the lawyer

because the lawyer can not get access to the funds and can not retain the interest earned and the client will get

the money eventually.) If it is most likely that the lawyer will keep the retainer and interest, then as a matter of

economics, the lawyer gets more of the economic benefit from the fund and ideally, the lawyer and not the

client should be the tax owner, even if the retainer must be segregated in a lawyer's trust account and not

commingled until earned. In any event, the legal requirements of noncommingling of prepaid fees are rare

outside of lawyer's retainers, so that the issue of who to tax on segregated trust funds is not very important to

the issue of prepayments generally. 52 FASB, Statement of Financial Accounting Concepts No. 3, Elements of Financial Statements of Business

Enterprises, ¶31 (1980). Accord, W. Paton and R. Dixon, ESSENTIALS OF ACCOUNTING 211

(1958)(prepayments are loans by the customer because "the full amount is subject to return if for any reason the

services or goods are not provided.")

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time-value interest factor and the probability that the refund might or might not occur.

With the discounting for time value and probabilities, the refund obligation will

ordinarily be too small to be recognized by ordinary tax or nontax accounting.

For most prepayments in commercial situations, it seems that the likelihood of refund,

when the firm receives the prepayment, is too small or "speculative" to be recognized under

normal GAAP standards. GAAP accounting has a general standard for loss contingencies like

the possibility of refund. A firm must recognize a loss immediately if the loss is probable.

Improbable but reasonably possible refunds must be disclosed in footnotes, but do not reduce

reported income. Remote or speculative loss contingencies are ignored in the accounts. They

neither reduce income nor are disclosed in footnotes.53 If the chances of refund of a

prepayment are greater than 50%, then it is correct under the GAAP general contingent-loss

standard to offset the prepayment with a debit for the refund loss, which would prevent the

prepayment from being considered income

Refunds, however, rarely seem more likely than not to occur. Lawyers seem especially

attached to their retainers -- they tend to hug their dollars until George Washington sings.

Performance undoubtedly does have some effect in reducing the chances of repayment --

although with malpractice or disgruntled customers, some possibilities of large payments back

to the client remain even after performance. The chances of refund of the cash, however,

never does seem to approach 50% even before the cash is earned. Accounting, in any event, is

not deferring prepayments because of a studied judgment about the percentages of the

possibility of refund but because the prepayment is not earned. Just because a retainer is not

yet earned does not mean that is probable that it will be returned.

Tax law also cuts off insignificant obligations to repay. In order to have cash in hand be

considered a loan, rather than taxable income, the purported borrower must have an "intent to

repay" when the proceeds are received. The repayment obligation must be a fixed,

53 FASB, Statement of Financial Standards No. 5, Accounting for Contingencies ¶22-23, 8 (1975).

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noncontingent obligation when the proceeds are received. Thus thieves, embezzlers and

confidence men who claim they have no taxable income from the purloined cash because they

have a legal obligation to repay it are routinely treated as nonborrowers on the ground they had

no intent to repay when they received the cash. Commonly the cases involve thieves or

embezzlers who have in fact refunded the cash by the time their tax case reaches the court.54

Under an "intent-to-repay" standard, F could not avoid income because of the refund

obligation. F did not intend to refund the $l million without contingencies at the time he

received it. In the ordinary course of events, the parties expected F to earn and keep the

proceeds. An intent to repay would be a different case. If the money were intended to be just

in Fs hands temporarily that would be a parking or hiding of the client's money or disguised

loan and such temporary parking would not be a real prepayment. In "real" prepayments, the

parties wanted and expected the cash to stay with F.

As a matter of economics, in spite of the tax law and accounting treatment, even a small

or speculative contingent obligation to make a refund should be considered to offset F's net

worth from the $l million cash. The refund contingency should, however, be valued

realistically. If the refund right is worth say $1.69/per $l million, considering both time value

and the likelihood of refund, then $1.69 is the sole offset to income. If accounting is going to

be useful in valuation of the firm, the offsets to income and net worth should not exceed

54 United States v. Rochelle, 384 F.2d 748, 751 (5th Cir. 1967)(confidence man had income when investors

gave him money for nonexistent enterprises because he recognized no obligation to repay); Bradley v.

Commissioner, 57 T.C. 1, 7 (1971)(insurance broker who kept premiums without finding insurance coverage

had income not loan); Knight v. Commissioner, T. C. Memo 1984-376 (lawyer borrowing to repay other loans

had no bona fide intent to repay). The leading case for the standard, James v. United States, 366 U.S. 213

(1961) involved an embezzler from a labor union who for some mysterious reason was not required to return

the cash to the union.

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historical experience or other objectively verifiable measure.55 Treating a contingency worth

$1.69 as if it offset $1 million overstates the detriment of the contingency.

C. Costs.

1. Future Costs The retainer agreement between F and Z Inc. provided that Z Inc.

would bear all future costs, so that F has no future costs associated with the $l million

retainer. The hypothetical was set up to be pure profit, albeit profit earned in the future.

There are other prepayments that can be expected similarly to be pure profit. All

prepayments for services, including for instance, the upfront bonuses or "advances" to

athletes or authors are similarly pure profits because the costs the service provider bears are

so modest. Still, commercial contracts requiring future goods or services will commonly

require future costs.

Where there are future costs, the discounted present value of the future costs should be

subtracted from the prepayment to calculate taxable not-yet-earned profit. Future costs are

cash costs (and basis) and the costs need to be subtracted from gross receipts ("revenue") to

calculate the net, profit or "income" from the transaction. Net worth includes the discounted

present value of future cash receipts the firm will receive and consistently, net worth is

reduced by the net present value of future payments. Future costs must be valued

realistically, that is, they must discounted to reflect both time or interest value since the costs

lie in the future and also to reflect possibilities that the costs are avoided. The present value

of future costs can be viewed as a fund set aside for the benefit of payees of the costs and not

part of the wealth or standard of living of the firm receiving the prepayment.56 The profit

55 Cf. Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 545 (1979)(upholding Black Motor Car formula

requiring that bad debt reserve be determined from prior five year's experience). 56 It is beyond the scope of this article to settle whether the discounted present value of future costs should be

computed using a pretax interest rate or an after- tax interest rate. Under a pure income tax system, future costs

should be discounted at a pre-tax interest rate, the discounted present value should be included in basis and

-24-24

element of a prepayment is that part of the cash that is not offset by the discounted present

value of future costs. The profit element from an unearned receipt is an improvement in the

firm's net worth, which should be taxed immediately, even if it is not yet earned.

There will undoubtedly be cases in which the future costs are unknown and without

knowing the future costs, it is impossible to ascertain whether the firm's current receipts

represent profits or will be used up entirely by future costs. It would be misleading

accounting for a firm to attract investors on the basis of current receipts only to find that

there is no net return available for the investors because costs, having priority claims over

investors, ultimately prevent the firm from having any profits. Still the standards will be

different if we focus on the problem of future costs, rather than on whether the payments

earned. Many receipts, including for instance, F's retainer will have no future costs or no

material costs and we can state with as much confidence as accounting usually allows that deducted as related income comes in, interest should be deducted as it accrues, and the recipient of the expense

should pick up the interest as it accrues. Emil Sunley, Observations on the Appropriate Tax Treatment of

Future Costs, 23 TAX NOTES 719 (Feb. 20, 1984)(arguing that future costs discounted at pretax value should be

included in basis); Donald Keifer, The Tax Treatment of Reverse Investment, 26 TAX NOTES 925 (March 4,

1985)(supporting Sunley with helpful tables); William Klein, Tax Accounting for Future Obligations: Basic

Principles, 32-TAX NOTES 623 (August 10, 1987)(supporting Sunley with helpful spreadsheets); Theodore

Sims; Environmental 'Remediation' Expenses and a Natural Interpretation of the Capitalization Requirement,

47 NAT. TAX J. 703 (1994)(supporting Sunley with calculus). In "impure" income tax systems, such as our

own, however, there are powerful arguments for using real post-tax interest rates. The expense recipient is

often unidentifiable to bear the tax on current interest so that the prepayment receiver holding the cash invested

should bear tax, a proxy tax, on the investment income. Daniel Halperin, The Time Value of Money-- 1984, 23

TAX NOTES 751, 769-770 (1984)(discounting at pretax rates would allow income streams to go untaxed);

Daniel Halperin, Taxation of Disguised Interest: Taxing the Time Value of Money, 95 YALE L. J. 506, 526

(1985)(tax on debtor is a proxy tax).. In a system in which investments are available which systematically give

returns in excess of post-tax interest, moreover, using pretax interest rates to discount future payments included

in tax basis often leads to tax benefits that are more valuable than the payments themselves. are worth. Johnson

Silk Purses from a Sow's Ear, supra note 36, at 236. Where real after-tax interest is the proper theoretical

discount rate, there is an easily administrable proxy for the whole discounting process, which is to wait until the

expenses are paid before recognizing them. Id. at 263-264.

-25-25

the receipts represent profits. Unearned profits in excess of the present value of future costs

do increase net worth immediately.

2. Expiring costs. Treating prepayments as immediate income will also cause some

costs to be recharacterized as expenses, deductible immediately, rather than capital

expenditures. As a matter of theory, costs are capitalized so as to be set on the balance sheet

as assets (i.e. "basis") to be used against future income. Many capital assets are nothing but a

cost stored on the balance sheet to be used against future revenues.57

Assume now, for instance, that as soon as F settled his contract with Z Inc., he went out

and paid $50,000 to an investment banker and $50,000 to firm specializing in soliciting

shareholders' votes, so as to be sure to have those services available (or to deny them to the

enemy) should a takeover battle for Z Inc. arise during the next five years. If F's income

were spread over the next five years -- either because Z Inc. paid it over five years or because

the recognition of the retainer was deferred -- then it would be appropriate to capitalize the

two $50,000 payments. The payments do not create an income-producing asset, anything

like an interest-bearing bank account, and the payments probably have no salvage or salable

value if they prove to give F no benefit. Still the two $50,000 payments are related to or

matched with the future income from the Z Inc. contract and they need to be set up as asset

on the balance sheet and as basis for tax so that they can be deducted against the future

income to which they relate. If, however, all of the revenue from the Z Inc. transaction is

found at the time of prepayment, as this article advocates, then the two $50,000 payments

should be deducted ("expensed") immediately against the prepayment so that only the net

profit is taxed. Once the revenue is accounted for by taxing the prepaid receipt immediately,

the costs should be treated as expired costs, deducted immediately, because there is no future

income to which the costs can be said to relate.

57 [S]ome assets are just expenses not yet charged to operations but deferred to future periods." Ted Fiflis,

Homer Kripke, Paul Foster, ACCOUNTING FOR BUSINESS LAWYERS: TEACHING MATERIALS 45 (3d. ed. 1984).

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3. Recovery of capital

A further issue on costs is whether a prepayment may be a recovery of basis where a

deduction for loss of basis would not otherwise be recognized under realization norms.58 The

issue comes up, for instance, in prepaid interest in which an investor-creditor commonly has

both gain from an interest prepayment and also an unrecognized loss in the capital account.

It would be quite reasonable to treat the prepayment as a recovery of basis and tax exempt.

There is, however, authority that says that the prepayment is taxable, but the economic loss

may not be recognized. The issue, however, does not affect the core case here, i.e. prepaid

compensation or bonuses, where the taxpayer has no prior basis to recover.

Assume that an investor lends $300 for four years at a fixed interest rate of just under

7-1/2%. When the principal is repaid in four years, the borrower must repay the $300 plus

another $100 to pay the compound interest for the period or a total of $400.59 Every $3

dollars will grow to $4 and a future $l is then worth only 75¢ now. Assume, secondly, that

the debtor on the note prepays the whole interest amount to the investor, as soon as the $300

is lent. The $100 interest is thus settled with an immediate prepayment of $75.60

Under the rationale of this article, so far, the $75 prepayment is properly taxable

income when received, unless there is some exemption. The cash receipt is the only real

transfer of income between the parties. Rental value of capital, like taxpayer work, is not

something that can be used to offset otherwise taxable cash received because if rental value

counted, interest could never be taxed. There are also no future costs associated with the $75

interest.

58 The issue discussed in this section was identified by Professor Daniel Halperin, although he is not

responsible for my formulation or conclusions.

59 $300 *(1+7.46%)4= $400

60 $100/ (1+7.46%)4 = $75.

-27-27

The investor, however, has no overall gain upon making the investment: The investor

has paid $300 cash and in return she got back two items, $75 cash back immediately and a

right to get back $300 in four years. The right to get back $300 in four years, however, has a

present value of only three-fourths or $225. Thus the $75 the investor gained as interest was

lost in capital. Together interest return and the capital return are equal just to the $300

amount the investor has paid out. As we get closer to the terminal $300 payment, the

investor gets richer by accrued interest, starting at 7.5% of $225, but there is no improvement

in overall wealth immediately when the prepayment was received.

Professor Daniel Halperin has argued, with considerable appeal, that the tax law

needs to recognize the investor's true net position either by excluding the prepayment, until it

is earned, or by recognizing the loss in capital.61 There is authority for treating cash receipts

as a tax exempt recovery of capital, that reduce basis instead of being taxed, because of

losses associated with the transaction.62 On the other hand, courts sometimes gotten stubborn

about the issue and have treated things called interest as income in full, even though it was

clear that the bondholder's overall position was a loss.63 The Treasury Regulations are

61 See also, Scarborough, supra note 27, 69 TAXES at 808 n. 64 (prepaid interest is just reduction of amount

borrowed).

62 In Commissioner v. Pennroad Corp., 228 F.2d 329 (3d Cir. 1955), the taxpayer received $15 million in

settlement proceeds because it had been forced to make bad investments by the illegal conduct of its corporate

affiliate. The IRS claimed that a portion of the $15 million was taxable investment income received for the first

time by the taxpayer, but the Court held that the entire $15 million was tax-exempt recovery of capital because

the taxpayers overall losses from the illegal conduct far exceeded the $15 million settle. In Madison Fund v.

Commissioner, 365 F.2d 471 (3d Cir. 1966), the Court held that the exempted portion reduced the taxpayer's

basis in the various investments.

63 In Reggio v. United States, 151 F.Supp. 740, 741 (Ct. Cl. 1957), the court held that bond holder was taxed on

settlement paid when issuer reduced interest rate because the payment was in the nature of interest. It was clear

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inconsistent on the underlying issue. Recent regulations allow prepaid interest to be treated

as a recovery of capital,64 but older regulations require prepaid rent to be included

immediately no matter what the taxpayers method of accounting.65

Dropping the distinction between principal and interest also, quite reasonably, leads

to an exemption for the prepaid interest. The $300 paid out by the investor and $75 return

occurred simultaneously and, viewed just as cash flows, they net. In cash flows, the investor

has $225 net cash out, and the $300 cash in four years in the future. Under that reasonable

view, there is no net receipt of any kind and hence no prepayment that needs to be

considered.

A recovery of capital rationale differs, however, from a 'do-not-tax-unearned-income'

rationale. A taxpayer has no recovery of capital argument if the taxpayer has no basis to

recover. In the core case of prepayment compensation with a retainer, a bonus or advance,

the service provider has no basis in the services to recover. Similarly, if for some reason, an

investor has no remaining basis in the debt principal or rental property, there is no argument

that the prepaid investment income should be tax exempt. A recovery of capital rationale for

exempting prepaid income also leaves the taxpayer with less basis in principal or rental

property should the property be sold or depreciated before the time of earning. Where the

recipient has no basis, the recovery of basis issue does not arise.

from the transaction that the reduction of the interest rate hurt the bondholder considerably more than the cash

he received in settlement helped, but the court held that the bondholder had income in lieu of interest and also

unrealized loss on the bond. Cf. Hort v. Commissioner, 313 U.S. 28 (1941)(basis may not be used to offset

prepaid rent)

64 Treas. Reg. §§1.446(e)(1)(iii), 1273-2(g)(2), 1.1275-2(a)(1)(1994)(prepayments are reduction of principal or

of issue price and are interest only to the extent interest has accrued), which is an unhighlighted change from

Proposed Treas. Reg. §1.446(e), 57 Fed. Reg. 60750, 1993-1 C.B. 734, 741 (1992).

65 Treas. Reg. §161-8(b)(1957).

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II.. Bad Financial Accounting

Deferral of not-yet earned income is also inconsistent with the purposes underlying

financial accounting. "Generally Accepted Accounting Principles" or GAAP refers to the

system of financial accounting used by corporations to report their operations and economic

position to outside shareholders and to the stock market as a whole. Under Securities

Exchange Commission ("SEC") requirements, corporations must conform their financial

accounts to the standards of the Financial Accounting Standards Board and its

predecessors.66 GAAP standards are also widely used, beyond the range of the SEC

requirements, to describe the firm to outside shareholders and creditors ( or potential

investors or lenders) who can not ask for more customized reports.67

Current GAAP, in fact, requires that prepaid, unearned receipts be deferred until

earned, but GAAP should not. The reasons that deferral misdescribes the firm as a matter of

economics, first, also make deferral bad accounting. There is, secondly, no general limitation

on accounting income to earnings alone and the reasons that lead accounting to abandon the

earnings-only income statement are also reasons to end deferral of not-yet-earned income.

A. Bad Economics is Bad Accounting

66 Securities Exchange Commissioner, Accounting Series Release No. 150 (1973)(financial statements must

follow Financial Accounting Standards Board promulgations or they are misleading). While FASB standards

are mandatory, they do not cover all accounting issues and even when there is a governing standard, there is not

necessarily a unique permissible result for a set of facts. As indicated by the "generally accepted" in GAAP,

GAAP started as a loose system of consensual rules that left considerable discretion in reporting. The FASB

standards, however, are commonly very detailed as to where to draw lines. 67 FASB, Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Financial Enterprises,

¶28 (1977)(financial accounting is for external users who do not have the authority to prescribe the information

they want from the firm); E. Press &J. Weintrop, Accounting Based Constraints in Public and Private Debt

Agreements, 12 J. OF ACC'TING & ECON. 65 (1990)(GAAP accounting is frequently used in debt covenants).

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The reasons that make deferral a bad description of the economics of the transaction

(part I) have persuasive power, even under the conventions of financial accounting used to

report to investors. The time-blindness of the current GAAP rules on prepayments, for

instance, is not forgivable just because GAAP standards govern reporting to outsiders.

Outside investors need to consider present-value discounting when deciding whether to

invest or retain an investment in the firm. Deferral of prepayments means that the accounts

presented to the outside investors fail to reflect present-value net worth of the firm. The

Financial Accounting Standards Board is increasingly incorporating time-value-of-money

concepts into GAAP; it is just that the reforms have not yet reached unearned receipts.68

Similarly, the argument made by accountants that future services or other consideration

should offset profits and turn prepayments into loans sounds like an economic argument.

The reasons that make the liability argument untenable as an economic description of the

firm also means that the argument is not tenable under a financial accounting. Similarly,

GAAP has general standards about when to take account of contingencies that are like a

refund;69 it just does not apply those general standards to the contingency to refund a

prepayment. Accounting, in sum, should report the unearned profits of the firm because the

unearned profits improve the real net worth of the firm, even though the profits are not yet

earned.

Financial accounting often departs from financial theory that outside investors need to

use because financial theory requires too many guesses about the future or too much

judgment about value. On the issue of not-yet-earned receipts, however, it is immediate

recognition which is the simpler, less-judgment-requiring rule and deferral which is the more

complicated rule. Deferral requires that the accountants ascertain what services were called

for and when they are performed, when the parties themselves may not have settled that in

68 See discussion, supra notes 32-42 and accompanying test. 69 See supra note 53 and accompanying text.

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their contract or even care: F and Z Inc., for instance, may know only that whatever F does

is worth $1 million as of year 0. All the work of ascertaining when the receipts are earned

degrades the quality of the information by misstating the time value of the receipts. As

explained in the next section, accounting moved from an earnings-only income statement to a

comprehensive income statement in order to reduce the judgments that management and its

auditing accountants were required to make and the reasons fro abandoning the earnings-only

income statement seem to imply abandoning deferral of not-yet-earned profits as well.

B. Earnings under the Comprehensive Income Statement.

The requirement that profits must be earned to be recognized is awkward to maintain

under GAAP, because the standards of the "comprehensive income statement," income is

recognized even though the income does not qualify as "earnings." The comprehensive

income statement, mandatory since 1966, includes both earnings and extraordinary items.

Since the "earnings" aspect of an item does not matter at all in determining whether to

recognize income, it is difficult to see why the "earnings" aspect matters in determining when

to recognize income.

Prior to 1966, GAAP sometimes allowed firms to use earnings-only income statements

that excluded "extraordinary items." Extraordinary items were defined as large items that are

clearly not identified with the usual or typical business operations of the year.70 In 1966

70 The permission for the earnings-only statement before 1966 was equivocal, allowing only "a possible

exception " under which the large unearned amounts would be excluded. AICPA Committee on Accounting

Procedure, Accounting Research Bulletin No. 32, Income and Earned Surplus ¶11 (Dec. 1947). The prior

history of "earnings" and "extraordinary" items is described in Leopold Bernstein, ACCOUNTING FOR

EXTRAORDINARY GAINS AND LOSSES 15-39 (1967) and Weldon Powell, Extraordinary Items, J. OF ACC'TANCY

31 (Jan. 1966).

It is not clear that Fs $l million would be excluded from income even under an "earnings"-focused

income statement. Extraordinary items mean, for instance, large, fortuitous, non recurring gains or losses from

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GAAP standards were amended to mandate a "comprehensive" statement of income and

prohibit the earnings-only statement.71 With the death of the earnings-only income

statement, nonearnings extraordinary items are now segregated in their presentation on the

comprehensive income statement, but they are part of the income statement.

The impetus for repeal of the earnings statement came from academic accountants72 and

from the SEC. The SEC argued in favor the comprehensive income statement, primarily to

reduce the scope for management editorializing and to reduce the responsibility of auditors to

second guess management:

"This desire to prepare statements in a form more readily usable in estimating

the future has led some to attempt to present what can be called a "normal" income

statement, the inference being that the statement shows about what can be expected

to happen year after year. The broad justification alleged for the practice is that if accidents or market fluctuations, especially on investments that are not related to the firm's core business. The

fee does arise out of F's core business and it might well be recurring.

Even under the earnings-only income statement, extraordinary items were not necessarily tax exempt.

Extraordinary items were closed directly to surplus (net worth) when recognized, by-passing the income

statement, but they had to be disclosed. The only difference between earned and extraordinary amounts under

the earnings-focused income statement was whether the item would be publicized on the income statement.

Many extraordinary items were still taxable to the firm. 71 Accounting Principles Board, Opinion No. 9 ¶17 (1966)(net income should reflect all items of profit and

loss recognized during the period, but extraordinary items should be shown separately within the income

statement). See also Financial Accounting Standards Board Concepts No. 6, Elements of Financial Statements

¶70 (1985)(comprehensive income includes any change in equity during accounting period, except distributions

and contributions by the owners).

L. Todd Johnson, Cheri Reither & Rober J. Swieringer, Toward Reporting Comprehensive Income, 9

ACCOUNTING HORIZONS 128 (1996) reiterate the comprehensive income principle and describe the occassional

departure from the principle allowed by Statements of Financial Accounting Standards. 72 AM. ACC'TING ASS'N., TENTATIVE STATEMENT OF ACC'TING PRINCIPLES UNDERLYING

CORPORATE FINANCIAL STATEMENTS 62 (1936)(arguing that income statement should reflect all

recognized revenues and costs, regardless of whether they are the result of operations, so that over a period of

years, income will report all gains and losses).

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the actual results of the year's operations are unusual a reader may be misled into

thinking the abnormalities will recur and that the best, if not the only way, to avoid

such misconceptions is to "normalize" the statement--that is, to exclude therefrom

the effects of some or all of the conditions which in the opinion of the draftsman are

deemed to be unusual.

"The dangers inherent in such a practice are numerous. In the first place, the

draftsman's judgment as to what is abnormal can scarcely be considered infallible.

In the second place, there is certainly as much danger that the reader will fail to

understand what has been done by the draftsman as that he will fail to recognize

that the unadjusted statements are abnormal. Finally the method is extremely

susceptible of misuse through conscious or unconscious bias in making decisions as

to what is unusual or abnormal about the current year. To a degree, of course, the

care with which disclosure is made of the extent of normalization may serve to

minimize the possibility of misleading the reader. But in general, we are satisfied

that a statement purporting to reflect the actual results of operations is far less likely

to be misleading if abnormalities are explained than if they are eliminated by

adjustment in the statement even with an explanation of the elimination set forth in

a note. ..."73

The SEC's position was also part of a larger idea that accounting should avoid mixing

interpretation and prognostication into its reporting of the facts:

"[F]inancial accounting is ... concerned with what did happen, not with what

might have happened had conditions been different. And it does not attempt to forecast

73 Securities Exchange Commissioner, Accounting Series Release No. 53 (Nov. 1945) 145-46.

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the future even though it supplies much of the material used in making such a

forecast."74

Mixing evaluations and facts, proponents of the change argued, undermines the credibility

and usefulness of accounting reports.75

Proponents of comprehensive income also argued that the change to a comprehensive

statement was inevitable, given the expanding view of the mission of a corporation. The old

view, it was argued, was that a corporation's mission was to bake bread, or make cars or do

whatever the core business was, whereas the new view is that the corporation is to do

whatever made money for its shareholders, even if that mean activities far removed from core

business. Extraordinary items make or lose money for the shareholders.76

Finally, the move toward the comprehensive income statement was influenced by

valuation theory. The value of any asset, including the value of a whole firm, is nothing

but the discounted present value of the net cash flows it will generate. A firm's cash

flows can be very irregular, but if accounting is to serve the process of valuation, it must

preserve the information about the pattern, that is, when and how much cash comes in.

Bonright, for instance, criticized GAAP accounting in 1937 as artificially converting

what is actually a highly irregular flow of cash into a standard flow called "net income."77

It is difficult to see how the deferral of F's $l million unearned receipts survived the

demise of the earnings-based statement in 1966. If accounting is "concerned with what

did happen" and does not "attempt to forecast the future" and if accounting should

preserve information about when cash comes even if it is not from the firm's business,

then profits received should be income, even if the profits are not yet earned. Amounts

74 Id. at 143. 75 Leopold Bernstein, ACCOUNTING FOR EXTRAORDINARY GAINS AND LOSSES 61 (1967). 76 Id. at 70 (1967). 77 T. Bonright, THE VALUATION OF PROPERTY 903-904 (1937).

-35-35

are now GAAP income even if they are never earned. Why must we defer income

awaiting an event that ultimately does not matter for accounting purposes?

C. Nonrecurring items and prognostication

It could also be argued that investors need to have nonrecurring items excluded from

the financial income statement because nonrecurring items are not very good indications

about the future of the firm. Earning may not be a very good indication of whether the item

is recurring and, in any event, accounting in adopting the comprehensive income statement

seems to have tried to stop judging whether income items are recurring. Nonrecurring items

fit terribly into a price-earnings ratio, commonly used in the stock market, but if so, it is then

is the price-earnings instrument and not the reporting of income that needs to be corrected.

Deferral, in any event, is a terrible predictor of the interest or investment income that can be

expected from the unearned receipt because it will not allow the investable net worth of the

firm to be recognized.

1. Recurring is not usually a GAAP requirement.

Proponents of the earnings-only income statement, allowed prior to 1966, argued that

investors want to know about the future of the firm and that "earnings" were a better

indication of the future, with extraordinary items excluded.78 Ultimately any valuation

depends upon the future. A stock is a good buy if the discounted present value of future cash

it will generate is greater than the current trading price and it should be sold if the discounted

present value of future cash is less than the current price.

The fact that the retainer is earned or not earned does not tell us a great deal about the

recurrence in the future. Earned amounts do not always recur next year. Business profits

78 AICPA Committee on Accounting Procedure, Accounting Research Bulletin No. 32, ¶9-10 (Dec.

1947)(summarizing earnings proponent's position); G.D. Bailey, The Increasing Significance of the Income

Statement, 85 J of Accountancy 10, 19 (Jan. 1948)(arguing that accounting can maintain its position in our

national economy only if its determination of income is useful for making decisions for the future.)

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fluctuate and business firms go from feast to famine in the amounts they earn annually. On

the other hand, the $l million retainer may be typical for F, although not yet earned, and if

typical it should not be treated as if it did not yet exist. Many business selling consumer

goods also sell warranty or repair contracts that are a kind of prepayment for repair or

replacement. Those businesses can often predict with great accuracy what percentage of

sales, warranty receipts will represent and how much of that warranty receipt is profit79

Prepaid does not necessarily mean nonrecurring.

GAAP, elsewhere, has dropped out of the game of deciding whether income is

recurring. The decision to get management out of the business of predicting and auditors out

of the business of second guessing the predictions explains the 1966 prohibition of the

earnings-only income statement and the move to comprehensive income.80 Accounting

reports "Just the Facts, Ma'am." The facts are that F received $l million in year zero and

everything else is editorializing.

2. Price-earnings ratio

The stock market tends to value stock by a price-earnings ratio81 and price-earnings

ratio, as a tool, assumes that the earnings are a perpetual flow of cash, like interest on a bank

79 Cf, RCA Corp. v. United States, 664 F.2d 881, 883 (2d Cir. 1981) cert. denied 457 U.S. 1133

(1982)(taxpayer showed statistical records of warranty receipts to show that time of performance was

predictable). 80 See supra notes 58-77. Current GAAP states that accounting information is a "historical record," may help

those who desire to estimate the value of a business enterprise, but ... is not designed to measure directly the

value of the enterprise." FASB, Statement of Financial Accounting Concepts No. 1, Objectives of Financial

Reporting by Business Enterprises ¶37, ¶41 (1977). 81 A price-earnings ratio is just the inverse of an interest rate. Assume a $20 investment gives $2 interest per

year. The interest rate is $2/$20 or 10% and the price-earnings ratio is the inverse, $20/$2, or 10:1. Investors

are willing to pay more than the inverse of the available interest rate because of the assumption that the earnings

will grow, but even when earnings are assumed to grow, the price-earnings ratio comes from an assumed

perpetual interest rate plus a perpetual growth factor: Price = earnings / (interest rate - rate of growth of

earnings). The price-earnings ratio for growth is derived from series analysis of an assumed perpetual stream of

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account.82 Plugging a one-time-only receipt into a price-earnings ratio yields nonsense. The

receipt is multiplied by the price-earnings ratio to reach a stock price as if the receipt were

going to be replicated infinitely.83 Price-earnings, however, is a terrible measure of stock earnings, increasing by a perpetual growth rate each year. See,. e.g., Van Horne, FINANCIAL MANAGEMENT

AND POLICY 30 (8th ed. 1989). 82 If the $2 received on the $20 investment this year is the only amount the investor will receive that is not a

positive 10% interest rate, but a negative 90% or loss. 83 Plugging a one-time-only receipt into a price-earnings ratio magnifies the importance of the receipt by the

price-earnings multiplier. With a 10% available interest rate, for instance, the receipt gets magnified by 10. If

we assume Firm A's stock were valued at a price-earnings ratio of 10:1, then $l million reported earnings would

add 10 times the $1 mil or $10,000,000 to the value of the stock. The firm net worth, however, is up by only $l

million. Spreading out the years when the retainer income is recognized will reduce but not cure the

overstatement. If earnings becomes $200,000 per year because the retainer is earned over 5 years, then 10

times earnings will add only $2,000,000 to Firm A's net worth. The $2 million is twice as high as the real

improvement, but not ten times too high.

For truly nonrecurring receipts, the receipt needs to be divided by the price-earnings ratio to fit into the

perpetuity assumption. If we divide a nonrecurring $1,000,000 by 10, for instance, then the assumed perpetuity

will be $100,000. Using the 10 to l price-earnings ratio, the market will then increase the market value of Firm

A's stock by ten times the $100,000, that is, by the appropriate $1 million. Of course dividing an income item

by 10 just so the market and multiply it by 10 to get back to the simple truth seems somewhat silly.

Amounts that are recurring perpetually, on the other hand, do not need to be discounted by the price-

earnings ratio to fit into a price-earnings ratio valuation. If, for instance, this is the type of firm that makes $l

million a year in perpetuity, it should be valued at $10,000,000 given a 10% discount rate. For that matter, if

this is a firm that makes typical $200,000 in perpetuity, then it should be valued at $2 million.

Amounts that recur some, but not annually in perpetuity need to be translated into some intermediate

amount to fit into a price-earnings valuation. The present value of $l million every other year, given a 10%

discount rate, is $5,760,000, so that if firm A is going to receive $l million retainers every two years, the $l

million should be translated into a perpetuity equivalent of $576,000. The present value of $l million for three

years is $2,490,000, so that if firm A is going to get three of these and then quit, the perpetuity equivalent is

$249,000. Once the present value of the investment is known, translating real present value into a perpetuity

equivalent is just a matter of multiplying the present value by the prevailing interest rate.

Companies are not infinite, fixed amounts investments like money in the bank. They are highly

variable cash machines which sometimes give lots of good news and sometimes do not. It is not hard to

translate a present value into a perpetuity equivalent -- if the present value of future cash flows were knowable.

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value, precisely because earnings are volatile animals and not infinitely replicated interest. It

would be terrible to abandon a good measure of value (net present value of cash) for a

terrible tool (price/earning) just to fit into the misanalysis by investors who should know

better.

3. Investment income from the prepayment.

GAAP deferral is, indeed, a worse prognosticator about future investment income than

immediate recognition would be. With the assumed interest rate at 10%, F will make

$100,000 per year investment income. If F keeps reinvesting the interest, then his interest

return would be compounded as he earns interest on previously earned interest. The

$100,000 or more investment returns per year are quite comprehensible if we understand that

F has $l million net worth in year zero, but they become incomprehensible under GAAP

balance sheets. In the first year after receipt, F will make $100,000 net interest on what

appears to be zero net worth. Lawyer F, viewed as a firm, appears to have found a way to

make investment income without any net investment worth. After one full year of the

retainer period, F's $100,000 investment return will be earned on what appears under GAAP

statements as a balance sheet investable wealth of only $200,000. The firm thus seems to

have found a way to make 50% return on investment ("ROI"). The infinite and then the 50%

ROI turns out not to be predictive, unfortunately, because the firm's prodigious productivity

drops from 50% 84 to 25%85 to 16.7% 86 to 10% as the deferred income is booked as revenue

and so shows up in net worth . The extraordinary early ROIs, alas, turn out not to be a very

good predictor about the future because they were just an artifice of bad accounting: The

But one should not translate value from present value, which is based on a good theory of value, to a price-

earnings yardstick, which is a terrible theory of value, because it presumes a perpetuity, just to satisfy stock

investors who should know better. 84 50% of balance sheet capital (i.e. $100,000 on $200,000 GAAP capital). 85 $100,000 on $400,000 GAAP capital. 86 100,000 on $600,000 GAAP capital.

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extraordinary ROIs arise solely because net worth amounts used as the divisor in the

calculation of ROI so badly understated the firm's real invested capital. For prognosticating

future investment income, deferral under GAAP is misleading, where immediately

recognizing prepayments would not be.

III. Bad Tax

A. Bad Economics and Accounting make Bad Tax.

Deferral is bad tax for many of the same reasons that it is bad economics and bad

financial accounting. If anything, the arguments for deferral raised (and rejected) under

financial accounting have less force under a comprehensive income tax. Even if GAAP

properly allowed deferral, however, not-yet-earned receipts should still be income for tax

purposes.

1. No earnings requirement in tax.

Taxable income does not need to be earned, ever. In 1966 GAAP moved from

allowing an earnings-only income statement to requiring a comprehensive income

statement. There was a similar shift, occurring earlier in time, from an earnings

perspective to a comprehensive income perspective in the federal tax definition of

income. Early in the income tax, income within the purview of the 16th Amendment was

defined to include only earnings, "derived from capital or labor or both combined."87

The articulation that income includes only earnings has now been abandoned. The tax

base is now said to include all "accessions to wealth" even if not earned. 88 Under the

comprehensive tax perspective, the income tax includes damages and includes windfalls

87 Eisner v. Macomber, 252 U.S. 189 (1920)(stock dividend); Edwards v. Cuba RR, 268 U.S. 628, 633

(l925)(government subsidy could not be taxed because it was not earned); S.O. 132, 1-1 C.B. 92

(1922)(reversing prior position, IRS holds recoveries under suit for slander, libel and alienation of affections

are not income because they are not derived from labor or capital or both defined.. 88 Commissioner v. Glenshaw Glass Co., 348 U.S. 428, 426,432 (l955)(punitive damages are taxable)

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that could never recur and which have no predictive value as to the taxpayer's future

receipts.89 Comprehensive income philosophy thus guides tax as well as accounting.

Unearned, nonrecuring amounts, moreover, would also be taxed even if they were not

part of financial reporting income.

2. tax-free Capital.

Failing to recognize F's real net worth is misleading for financial accounting purposes

because accounting should inform investors about the true investment value or "bank

account" value of the firm. By failing to reflect the firm's investable capital, the accounting

will fail to predict the firm's future investment income.90

There is a parallel and more serious error in failing to recognize investable capital

under the income tax, in that the investable capital from the prepayment will become a tax

free source of investable capital. In a true income tax, investments are made and continued

only with after-tax "hard money." Within a system that generally requires hard money

investments, the ability to make investments with pretax " soft money" is an extraordinary

privilege. The privilege is usually as valuable as not paying tax on the subsequent income

from that investment.91 F can invest the $l million, just as any other lawyer can invest her

earnings. The fact F's $l million is investable for the interim period and F can keep the

returns implies that the principal of that investment should first be subjected to tax. 3. Conservatism. The primary function of Financial Accounting Standards is to protect outside shareholders and investors against management overstatement of the firm's income and assets. GAAP accounting is, accordingly, conservative by tradition and instinct: Possible errors as to measurement are resolved in favor of understatement of assets and 89 Cesarini v. United States, 428 F.2d 812 (6th Cir. l970)(found property); Treas. Reg. §l.61-14(a)

(l958)(accord). 90 See supra note 72-74 and accompanying text. 91 The thesis originates with Brown, Business-Income Taxation and Investment Incentives, in INCOME,

EMPLOYMENT AND PUBLIC POLICY: ESSAYS IN HONOR OF ALVIN H. HANSON 300 (1948). See,

e.g. Calvin Johnson, Soft Money Investing under the Income Tax, 1989 ILLINOIS L. REV. 1019 (1990) for

one lawyer's explanation.

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income.92 Conservatism is an ambiguous ideal for financial accounting because it is commonly in the interest of management to deflate reported income rather than puff it up.93 Still, the usual situation finds management trying to puff up reported income currently and the accountants using financial standards to control the puffery. For tax purposes, by contrast, the regulatory problem is not preventing puffery but preventing understatement of income. Management finds it rational to puff up reported income only in unusual circumstances. Financial accounting standards, set up as a defense against puffery, tend to serve very poorly as a defense against deflation of income. As the Supreme Court has said, GAAP, with its fundamental principle of conservatism, can not be the "guiding light" for tax.94

Deferral of unearned profits is consistent with conservatism because it tends to reduce

the income and assets of the firm in earlier periods. GAAP's time blindness does not always

serve conservatism.95 The earnings requirement seems better explained by an attempt to

identify core operations that might predict the future than by an attempt to be conservative.

Even with a conservative slant, there does not seem to any good reasons in F's situation why

F's $1 million retainer should be reported as if it had a present value of only $758,000.

Nonetheless, to the extent that GAAP deferral of unearned amounts is explained by

conservatism, that conservatism has no place in tax accounting. Both tax accounting and

92 Accounting Principles Board, Statement No. 4, Basic Concepts and Accounting Principles ¶171 (1970). See

Sterling, Conservatism: The Fundamental Principle of Valuation in Traditional Accounting, 2 ABACUS 109

(Dec. 1967). 93 It is in a firm's interest to deflate income when trying to repurchase stock from existing shareholders at the

lowest price possible and when negotiating with organized labor, the tax collector or ex-spouses seeking

alimony to give them the least amount of money possible. Also, conservatism in earlier periods usually means

overstatement in later periods because conservatism pulls expenses and losses into earlier periods and pushes

reported profits into later periods. Pushing income into later periods can also be a form of manipulating the

stock market in favor of a company selling stock by setting up beautiful trend lines.

94 Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 542 (1979). 95 See supra note 39 discussing Financial Accounting Standard No. 15, which allowed the Savings and

Associations to understate their losses from restructured loans.

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financial accounting are regulatory systems, leaning against management interests to control

self-serving reports by management, but to control management in financial reports and in

tax reports, the regulatory systems must lean in opposite directions.

B. Defenses of Deferral Unique to Tax.

There are at least two defenses of deferring prepayments for income tax purposes put

forward by academics that have no parallel in nontax accounting. Professor Daniel Halperin

has argued that the customer paying a prepayment should bear tax on interest earned on the

prepayment before the prepayment is earned and Halperin would shift the tax burden on the

interest back to the customer by imputing an interest payment. Professors Reed Shuldiner

and Alan Gunn have argued that imposing tax on the recipient of a prepayment imposes a

double tax on the same wealth because the payor must capitalize the prepayment.

Both arguments prove too much, in my view. Their tax-saving rules apply as

comfortably to earned cash receipts as to unearned receipts and there is nothing special about

prepayments that makes prepayments especially appropriate beneficiaries of their tax-saving

rules. Once one assumes the premise argued here, that "earning" is not a viable requirement

for the recognition of income, then there is no remaining force to either argument.

1. Shift the Tax Burden Back to Client.

a. Halperin's case. Professor Daniel Halperin has argued that a prepayment is a loan in

which the payor of the prepayment can expect to receive interest. Identifying the loan and

interest will shift the tax burden on interim returns from the $l million away from F and

"back" to the client. Halperin argues that F receives a loan in year zero and then receives

enough compensation to pay back the loan and interest in the years 1-5:

"In every transaction involving the delivery of goods or services, there is a time of

'actual economic performance,' when the buyer obtains the benefit of the goods or

services that are being purchased. ... [I]f payment is made before the time of actual

economic performance, the buyer [client] has made an implicit loan to the seller [F],

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and the seller [F] will reduce the price charged to reflect the interest implicitly due the

buyer [client]. As in the case of interest-free loans, the transaction can be

disaggregated into two separate components -- a payment for goods or services and

disguised loan.96

Lawyer F performed services in years 1-5 of more than $l million to take account of interest.

The fact that we can see no further payments from client to F after year 0, under Halperin's

analysis, is just the resultant of compensation paid by the client and loan repaid by F. To

understand the economics, Halperin argues, we must disaggregate the zero payment in years

1-5 into its constituent parts, i.e., compensation going from client to F and loan repayment of

principal and interest going from F to client.97

Under Halperin's construction, unlike the GAAP loan, F pays interest to client Z Inc.,

and the interest that F pays makes the construction consistent in present value terms with the

fact that F has performed services worth $l million (not $758,000) and that client has paid F

$l million in net present value (not $758,000).98

The function of Halperin's system is to tax the client, rather than F on the interim

income. Prepayment is especially abusive Halperin argues, where the recipient of the

96 Daniel Halperin, supra note 56, 95 YALE L. J. 506, 516 (1985). Robert Scarborough, supra note 27, 69

TAXES 799, 802 (accord). 97 Cf. IRC §7872 (loan without explicit interest reanalyzed as interest paid plus return payment moving in the

other direction) 98 Unlike GAAP, Halperin's reconstruction would preserve the real $l million present value of the

compensation in year 0, where GAAP would not, because Halperin factors in interest. F would be able to defer

compensation until after year 0, but the amount of taxable compensation would be augmented to cover interest

on the $l million. If we assume that F performs services in equal portions each year, F would have

compensation of $263,798 per year, rather than just $200,000, because $263,798 is the annuity needed to give

the client a 10% interest on a $l million loan where payments (covering principal and interest) are constant over

5 years. under the standard annuity formula of annuity = $1 mil *10%/1-(1+10%)-n. present value of the

$263,798 annual is the same as the $l million in year 0, using the pre-tax given interest rate. Halperin's

reconstruction, unlike GAAP, does not change the pretax present value of F's receipts. .

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prepayment is tax exempt and the expense is not deductible: A mother might prepay college

tuition many years before her son starts school, thereby paying for her son's college largely

with investment accumulation that is taxed neither to her nor to the tax-exempt college.

Halperin's would shift the tax burden on the interim investment income back from the college

to the parent. Having created his shifting to prevent abuse, however, Halperin would also

apply its logic when shifting reduces taxes on the transaction. Halperin would thus shift back

the tax burden from F to the client, under his loan construction, even when F is in the

maximum tax bracket and client is an net-operating-loss corporation that will pay no

foreseeable tax.

By shifting the tax burden from F to the client, when the client is tax exempt, Halperin's

reconstruction reduces the tax burden on the recipient of a prepayment, measured in time

value terms, below the burden from a normal income tax. Assume, for instance, F is in a

40% tax bracket and that F will accumulate the $l million receipt and its earnings for the full

five years. In absence of tax, the fund would grow to $l mil*(1+10%)5 or $1,610,510.

Normal income tax would reduce both the investable fund and the rate of growth by 40%, so

that F would have $l mil*(1-40%)*[1+10%(1-40%)]5 or $802,935 at the end of five years.

Alternatively stated, the effective tax rate on the investment is 40% of taxable income.

Deferring the tax until the compensation is earned reduces the impact of tax on F. If we

assume, changing the core hypothetical, that F's services come only at the end of five years,

F would pay tax only at the end and the $1,610,510 pretax investment would be reduced to

only $966,306 by a 40% tax imposed only at the end.99 That, however, is exactly what would

be expected by a zero tax on investment income, when an after-tax $l million times (1-40%)

or $600,000 can be invested at 10%.100 The results are an illustration of the Cary Brown or

soft money thesis: the ability to invest untaxed soft money is as valuable as not paying any

99 $1,000,000 * (1+10%)5 * (1-40%) = $966,306

100 $1,000,000 * (1-40%) * (1+10%)5 = $966,306

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tax on the interim income.101 The effective tax rate on F's interim investment return until the

deferral ends is zero, no matter how long the deferral lasts. The zero effective rate of tax on

F's investment income is what Halperin intended. The construction was intended to shift the

tax burden on the interim interest from F to the client.102 If Z Inc. were in the same tax

101 See supra note 90 and accompanying text. 102 If the compensation (and deemed debt repayment) occurs prorata over the years, both the deferral and the

reduction in effective tax rate is less. If the compensation (and debt repayment) is assumed to occur in equal

segments over five years, each payment would be $263,797 per year, and F's $1 million would grow to

$892,231, after tax, calculated as shown on the following spreadsheet: i= 10.% t= 40%

year 1 2 3 4 5 6 1. Investment Fund (prior 1.+prior 9.) $1,000,000 $994,481 $982,079 $961,726 $932,224 $892,231 2. Pretax interest (10% of 1.) $100,000 $99,448 $98,208 $96,173 $93,222 Tax Calculations 3. Outstanding deemed debt (prior 1. less prior 6.)

$1,000,000 $836,203 $656,025 $457,830 $239,816 $0

4. Deemed Compensation. $263,797 $263,797 $263,797 $263,797 $263,797 5. Deemed Interest paid (10% of 3.) $100,000 $83,620 $65,603 $45,783 $23,982 6. Reduce Obligation $163,797 $180,177 $198,195 $218,014 $239,816 7. Taxable Income (2+4-5) $263,797 $279,625 $296,403 $314,187 $333,038 8. Tax @40% $105,519 $111,850 $118,561 $125,675 $133,215 9. After tax growth in fund (2-8) ($5,519) ($12,402) ($20,353) ($29,502) ($39,993) After Tax Rate (annual compound growth $600,000 to $892,231)

8.26%

Effective tax rate going from 10% to after tax rate

17.41%

The fund has an after tax annual rate of 8.26% compounded annually because $892,231 is amount that the after

tax capital of $l mil*(1-40%) or $600,000 would grow at 8.26% compounded annually. Effective tax rate is the

difference between pretax and post tax rate, divided by the pretax rate or here (10%-8.26%)/10% or 17.4%.

With longer deferrals, the effective tax rate drops further, although it never reaches the zero effective tax rate

that could be achieved if compensation were assumed to occur entirely at the end of the contract.

Halperin's loan construction would, incidentally, be slightly more valuable to F than GAAP. GAAP

would take the $l million principal into income in equal one-fifth segments per year. Under Halperin's system

F would take the $l million principal into income under a constant-rate annuity schedule that generates

compensation only as principal is repaid. The constant-rate annuity schedule is back end loaded in comparison

to equal straight line one-fifth segments. (A greater proportion of early payments are interest in an annuity-

schedule because interest is high when the outstanding balance is high; later payments are mostly principal

because the interest burden is so much lower). According to my calculations (using the same procedure and

assumptions as in above table) under GAAP, F's $l million fund would grow to only $887,258 after 5 years

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bracket or higher, then the tax saved on F's side would be made up on Z Inc.'s side, but when,

as here, F is high bracket and Z Inc. pays at zero rate, the construction only saves tax.

b. Critique of Halperin: F Just Has Money. The major difficulty with Halperin's tax

shifting construction is that there is no cash receipt, of any kind, to which it can not be

applied to and there is nothing special about F's economic position that makes F stand apart

as an appropriate target of the construction.

For all objective appearances, F is just like someone who has just made a million. F

starts with $l million cash and net worth in year zero, he can use or invest the $l million as he

chooses, and if he invests the $l million it will grow to $1,610,510 at the end of five years.103

Normal debtors who borrow $l million, by contrast, have zero net worth in year zero, they

must hold and invest their $l million to be able to pay principal and interest to the lender and

at the end of the five years they will have nothing if all they have done is make the going

10% return on the $l million. There is nothing about F's $l million that makes it look like a

loaned $l million or distinguishes it from an earned $l million. While F must certainly

perform services, F's services can not count in tax or accounting to offset loan proceeds.104

Halperin creates virtual payments from Z Inc. to F and from F to Z Inc., as compensation is

earned, but the payments are virtual. No one can see them and they have no affect on either

F or Z Inc. What is different between an earned $l million and F's $l million is that F's $l

(slightly worse than the $892,231 under Halperin's system). The growth to $887,258 is an after tax growth of

$600,000 at 8.14% over five years and 8.14% is a reduction by tax at an effective rate of 18.6%. Halperin's

system would reduce the effective tax rate on F's investment income from a statutory 40% to an effective tax

rate of 17.4%, whereas GAAP would reduce the effective rate from statutory 40% to an effective tax rate of

18.6%

. 103 $l million *(1+i)5 =$ 1,610,510

104 See text accompanying supra note 47 (F has no basis in services; if services offset cash, then no

compensation could be taxed).

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million is not earned, but as argued consistently in this piece, future earnings makes no

legitimate difference in economics, accounting or tax..

The constructive loan from Z Inc. to F will have none of the normal accouterments of

loans that bona fide creditors insists upon to ensure repayment. There will be no fixed

schedule when repayment of interest and principal must be made, no account keeping track

of principal and interest on the outstanding debt, no note or other evidence of indebtedness

that the client can negotiate or assign, no loan officer checking credit history or debt/equity

ratios or ratio of current assets to current liabilities, no right to demand immediate repayment

of everything if a repayment check arrives after the 15th of the month, no security or

collateral or indenture agreement appropriate to a million dollar loan.. F on his part does not

have to reduce his consumption or savings in order to have some amount to repay. In the

ordinary course, F will keep the $l million to spend or invest. If there are justifications for

Halperin's system in shifting the tax burden back to the client, in sum, none of them come

from facts about F.

Since there is no indicia that F has a loan, it follows that (a) any cash receipt can be

reconstructed as a loan that defers tax, and (b) there are an infinite number of constructive

loans of different terms that have a present value of $l million and are consistent with the

facts of F's case. Since there are no repayments in fact, we can faithfully deem the

constructive compensation and repayments to occur over the next year or over five year or

over 100 years. The different terms have different tax impact-- the longer the term the lower

the tax burden in present value terms. But there is no cash but the first $l million and nothing

in the cash flows that negates an argument that the taxpayer has, not immediate cash, but a

100 year loan. Immediate taxation is also at least as consistent with the present value of the

services he performs as any deferred taxation is.

Halperin's argument focuses on unearned receipts, but his loan construction could be

applied, just as easily, to cash receipts that are not prepayments. Take, for example,

partnership draws given to a partner who has performed all of the work justifying the draw.

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The Treasury Regulations, to solve a technical problem in the operation of Subchapter K,

taxing partnerships, give benefit of the loan rationale to fully earned partner draws.105 There

is a similar technical problem with taxing partnership profits interests and one commentator

has suggested that the technical problem be solved by treating a compensatory transfer of

fully vested profits interest as if it were a loan of share of partnership capital, even if the

recipient's compensation has already been fully earned.106 For that matter, stolen cash can be

treated as a loan. Taxpayers caught with their hand in the till often argue that they were

merely borrowing the cash in hand and should not be taxed on their cash.107 Once the loan

construction is imposed across the line between prepayments and earnings, then partners and

thieves might as well get the benefit of the construction. Halperin's construction defers tax

and shifts the tax burden of interim interest back to some constructive lender. Since the

105 Treas. Reg. §731-1(a)(1)(ii)(advances or drawings against a partner's distribute share of income are taxable

only on the last day of the partnership's taxable year). Absent the rule, a partner with no prior basis in her

partnership interest would have gain from the sale or exchange of her partnership interest when the draw is

received and then would have income again on the same source when the partnership year closes, by reason of

her share of partnership income. Her tax on the draw would not prevent tax on year-end distributive share

because basis in partnership interest does not prevent the partnership from having income and because basis in

the partnership interest is not amortizable against partnership income. The system works well when partner and

partnership year close simultaneously, but it gives the partner a one year tax holiday, not reversed until the

partner leaves, when the partnership year closes after the partner's year, even though the partner has earned,

received and consumed the draw when received. 106 Leo Smolka, Commentary: Taxing Partnership Interests Exchanged for Services: Let Diamond/Campbell

Quietly Die, 46 TAX L. REV. 287, 305 (1991). 107 The court even bought the argument in In re Diversified Brokers, Inc., 355 F.Supp. 76 (D. Mo.

1973)(finding Ponzi-scheme operator had nontaxable loans rather than income-- so as to allow victims to

prevail over tax collector in bankruptcy of the thief). Compare United States v. Rochelle, 384 F.2d 748, 751

(5th Cir. 1967)(confidence man had income when investors gave him money for nonexistent enterprises

because he recognized no obligation to repay); Bradley v. Commissioner, 57 T.C. 1, 7 (1971)(insurance broker

who kept premiums without finding insurance coverage had income not loan); Knight v. Commissioner, T. C.

Memo 1984-376 (lawyer borrowing to repay other loans had no bona fide intent to repay).

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construction could be applied with equal force to any taxable cash and F has no special claim

to the construction, the construction is no more legitimate for F than for any taxable cash.

2. Shuldiner and Gunn: Double Taxation of the Payor-Payee in Combination.

Professors Reed Shuldiner and Alan Gunn, working separately, have each argued for

deferral of F's prepayment, not so much to achieve a fair or accurate description of F in

isolation,108 but because of the tax actually paid by the client, Z Inc., combined with F's tax.

Immediate taxation of prepayments combined with capitalization on the client's side of the

transaction, Shuldiner and Gunn argue, is a "double tax" that overburdens prepayments,

compared to normal tax. Thus Shuldiner argues that

"[A]ssuming the payor is not permitted an equal and offsetting loss, the effect of treating the

[pre]payment as income is to overtax the transaction. Overtaxing the transaction is generally inefficient,

leading to an alteration in the form of the transaction (with presumably greater transaction costs) and a

reduction in the number of such transactions."109

The comment assumes that on the client, Z In.'s side, the $ l million prepayment is a capital

expenditure that can be deducted only as it is earned. Capital expenditures usually represent

amounts on which a taxpayer has already paid tax on; by reason of capitalization, the client

can not the prepayment and recover the tax. Within those assumptions, then, both the client,

Z Inc. and F will have tax to pay on the $l million prepayment.110 108 See Gunn, Matching of Costs and Revenues as a Goal of Tax Accounting, 4 VA. TAX REV. 1, 21 (1984)("If

economic effects are measured solely from the taxpayer's perspective, the case for taxation on receipt appears

compelling"). 109 Shuldiner, supra note 9, at 296. Accord, Gunn, supra note 107, at 25 (arguing that for prepayments of

business expenses, "deferred taxation of receipts comes much closer to neutrality than current taxation, which

almost always discourages prepayments" --but conceding that prepayments can be discouraged without much

real damage); Scarborough, supra note 27, 69 TAXES at 802, 811 (immediate taxation of recipient combined

with capitalization by payor is double taxation of investment income; norm to follow is neturality, defined as

same results as no tax). 110 Sometimes it would not the client, Z Inc., who has paid tax on funds to make a capital expenditure, but

rather a creditor who lent the funds to Z or an equity investor who contributed the funds to X. Whether tax is

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There is some doubt as to whether the client must maintain a prepayment as a capital

expenditure. "Better" tax law does not allow the client Z Inc. a deduction for the $l million

paid. The $l million is an investment by the client that gives "significant benefits beyond tax

year,"111 and it is a properly treated as a capital expenditure, regardless of the client's method

of accounting.112 Still, capitalization of prepayments is not universal. Nonaccountant judges

have sometimes said that expenses are different from capital items by nature even if they are

prepaid and may be deducted immediately.113 The Tax Court rule, moreover, is that a

prepayment of product costs may be expensed by a cash method taxpayer if the prepayment

was non-refundable when paid and if the fact of the prepayment was negotiated between the

taxpayer and the recipient of the prepayment. The Tax Court presumes that there was a

nontax business purpose that legitimates the prepayment, if the taxpayer had chance to

bargain with the recipient.114 The Tax Court has allowed immediate expensing even for very

paid by the taxpayer or some predecessor, however, still we can usually presume that someone has paid tax on

the $l million fund to have it available to give to F. 111 INDOPCO, Inc. v. Commissioner, 112 S. Ct. 1039, 1045 (1992). 112 Johnson, supra note 90, 1989 ILLINOIS L. REV. 1019, 1074 (1990) 113 Waldheim Realty & Inv. Co. v. Commissioner, 245 F.2d 823, 825 (8th Cir. 1957)(prepaid insurance need

not be capitalized because expense is something different from capital asset). As a matter of accounting theory,

there is no metaphysical difference between a capitalized expenditure and a current expense except that the

former has continuing value contributing to future income and the latter has expired by year end. 114 Packard v. Commissioner, 85 T.C. 397, 428 (1985)(prepaid cattle feed); Keller v. Commissioner, 79 T.C.

7, 28 (1982)(prepaid intangible drilling costs) aff'd 725 F.2d 1173 (8th Cir. 1984); Van Raden v.

Commissioner, 71 T.C. 1083, 1105-06 (1979), aff'd on other grounds, 650 F.2d 1046 (9th Cir. 1981). There is

no logical power to the argument. The recipient of a prepayment might easily be an accommodation party who

is not hostile to an early payment of its receivables. Firms commonly tolerate an early or even prepayment of

their receivables, in the ordinary course of a trade or business, because their collection risks go down.

Syndicated shelter promoters, moreover, who are selling the tax advantages of prepayments have proven not be

very good enforcers preventing material prepayments.

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large, one-time-only, syndicated tax shelters.115 Thus, it is not can be assumed that customers

will uniformly capitalize prepayments.

Assuming that client does capitalize the $l million and that Z or its creditor or

shareholder has paid tax on the $l million given to F, the question becomes whether F should

get credit for the client Z's tax, so that F does not have to pay tax on the prepayment? If there

is a true earnings norm underlying tax, it is quite plausible that F should get credit for tax

paid by Z. Viewed as a tax on earnings, the income tax is an indirect tax on product or

harvests in the economy.116 A prepayment is a transfer payment that does not indicate that

there has been a product or harvest. We commonly allow the recipient a tax exemption and a

carryover of basis from the transferor when there is a nonproductive transfer payment not

associated with an earnings.117 If we accept client's tax as reason for not taxing F, we

plausibly should limit F's tax relief to the tax that the client has paid and not worry about

over-tax or double tax if client has paid no tax.118

115 In Haynes v. Commissioner, 38 T.C.M. (CCH) 950, 952, 954 (1979), for instance, a syndicated tax shelter

partnership bought $7.3 million worth of feed in late December little of which was used by year end. The Tax

Court allowed expensing of the $7.3 investment, notwithstanding its manifest materiality. Real access to the

common-law advantages of cases like Haynes, especially by nonfarmers who do not have mud on their boots,

has been drastically restricted by Congress by the enactment of a great number of anti-tax shelter over-rides.

See, e.g. IRC §263A(uniform capitalization), IRC §447(mandatory accrual rules); IRC §461(prepaid expenses);

IRC §464(deferring deductions until use of supplies); IRC §469(passive loss limitations). 116 Alvin Warren, Fairness and a Consumption-type Cash Flow Personal Income Tax, 88 HARV. L. REV. 931

(1975). 117 IRC §1015 (gifts), §362 (contributions to capital). Borrowers also get basis for purchases with borrowed

money; since they have to return the borrowing with cash that presumably carries basis, the borrower's use of

basis is only temporary. 118 Any tax relief given to F on his $l million dollar betterment should limited to the tax actually paid by the

client. Any tax relief should treat any tax relief under a "withholding" or "VAT voucher" model, that is, F

would get a tax credit only for tax the client, Z Inc., has paid on the $ l million used to fund the retainer and

only if the client gives him proof of the payment. Given that nothing about F from his own situation justifies

tax relief under the argument, it is only client tax if any that justifies the tax relief. If the client has not paid tax

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Still, in the end, tax is imposed on both earned and unearned income. There is no

reasonable distinction between earned and unearned amounts in terms of F's wealth or

standard of living. F pays tax on compensation. It is plausible that Z Inc. will have to

capitalize the $1 million paid to its lawyers and investment bankers should it be taken over,

even after the lawyers have earned their full fees.119 We would not allow F an exemption for

the earned fees just because Z Inc. capitalized them. Yet, the $l million receipt has the same

net present value improvement to F, whether F has earned the compensation yet or not.

There can be no general principle that a recipient of a capital expenditure should get an

exclusion for the receipt on the ground that the payment was capitalized on the other side.

The government makes revenue from the tax system only because when recipients pay tax on

a receipt, the payers do not immediately deduct the payment. There certainly can be no

general proposition that this dollar bill is tax exempt because somebody has already paid tax

on the dollar as it circulated. If there is a tax burden on the prepayment, it is no different

from the tax on earned amounts.

Client and F can avoid double tax and shift the burden on interim income back to

client by setting up a bona fide loan from client to F with a repayment schedule of principal

and interest. The repayment schedule could match compensation paid from client to F, but it

need not. Thus if prepayments are taxed, F and Z Inc. can avoid the double tax by setting up

an explicit loan, until the prepayment is earned.120

in fact, there is no overburden on the transaction and no claim for relief, either from F's own position or from

the client's proxy tax. 119 INDOPCO, Inc. v. Commissioner, 112 S. Ct. 1039 (1992)(target's legal and investment banker fees were

capital expenditures of indefinite life). 120 There may be some administrative values in requiring Z Inc. and F to undertake a real loan to avoid double

tax and shift tax on interest back to Z Inc. A constructive loan will not have real repayments so that we can not

catch Z Inc. in underreporting by looking at real cash received. A real loan will have real interest payments by

F and with real interest payments, we can ask on audit whether the interest payment are disallowed by IRC

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The availability of a bona fide loan to accomplish tax relief does not imply, however,

that we should create a constructive loan. As argued with respect to Professor Halperin's

constructive loan, so it is argued here that there is no limit to the cash receipts to which a

constructive loan could be imposed and nothing special about prepayments that call for

imposition of the constructive loan. There is nothing special about earnings: profits received

should be taxed, whether the profits are earned or not-yet-earned..

Conclusion

For over fifty years, accounting-oriented critics of the income tax have argued that the

tax law should follow the lead of the accounting profession and defer the taxation of not-yet-

earned receipts until the receipts are earned. The criticisms are misplaced. There is no

legitimate earnings requirement. There is no legitimate reason in economics, accounting or

tax law why an accession to wealth received by the taxpayer must be earned. Delaying the

recognition of profits received by the taxpayer profits until the profits are earned understates

the net present value of the transaction to the recipient of the transaction and understates the

contribution of the unearned profit to the taxpayer's wealth and standard of living. Deferral is

blind to the time value of money. Immediate taxation of not-yet-earned receipts better

describes the taxpayer, as a matter of economics and under more fundamental principles of

financial and tax accounting.

§265(a)(2)(disallowing deduction of interest incurred to buy or carry municipal bonds), §163(h)(disallowance

of deduction of personal interest in excess of investment income) or some other provision..

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