by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
randolphp@umkc.edu

FEDERAL INCOME TAX; DEDUCTIONS: D.C. Circuit rules that 1986 changes in Internal Revenue Code affecting real property transactions are invalid. Whimsey Limited Partnership v. Comm'r, _____ F.3d _____, 56103 WL (11th Cir. 1/15/97)

The partnership return was challenged in 1988 by the IRS on a number of grounds, and the partners have fought the Service bitterly for some time. This case has been bogged down in procedural wrangling and appeals of preliminary rulings for six years, before a lower court ruling favorable to the government. This appeal followed.

Most observers had expected the appeals courts to ignore the particular aspect of the case upon which the court rules here. It has been raised in several prior cases, and has been dismissed as very near a product of "anti-tax mania," not taken seriously by commentators, and perhaps not by the government.

The root of the holding is a 1922 decision by the U.S. Supreme Court, Jape v. Comm'r, 82 U.S. 512 (1922), in which the Court interpreted the recently adopted Sixteenth Amendment to the U.S. Constitution, authorizing the imposition of a tax on income "derived from any source" without division or apportionment of the proceeds of that tax to the various states. Despite the broad language of the Amendment, the Supreme Court ruled in Jape that there were further procedural hurdles that the Congress would have to leap before taxing transactions involving real estate. The Court reasoned that property taxation had been reserved to the States by the SixteenthAmendment, and that consequently no income tax on the proceeds of real estate transactions would be valid unless the Congress invoked a little used Constitutional device known as "classification and publishing," whereby the Congress would identify those aspects of a particular revenue measure that involved real estate transactions and notify the Secretary of State of each of the various states of the proposal in advance of enactment, to give the states the opportunity to challenge the reach of the revenue proposal prior to enactment.

In the seven decades following Jape, the Congress has followed the "classify and publish" practice routinely with regard to amendments to the Internal Revenue Code, even though the Service here argued that Jape had no basis in Constititional history and, in any event, was itself limited only to attempts by the Congress to limit or divert the revenue that States and subordinate entities obtained from ad valorem taxes on property. The D.C. Circuit panel, however, disagreed, citing not only documents from the original Constitutional Convention and the Federalist Papers but also records relating to the adoption of the Sixteenth Amendment itself.

The Tax Reform Act if 1986 included one of the most sweeping revisions of income tax law relating to real property taxaction in history. The legislation severely limited the ability of taxpayers to claim depreciation deductions in connection with such investment, both by changing the way depreciation could be computed and by placing limits on "passive losses" generated by such depreciation. Inexplicably, the Congress did not carry out the "classify and publish" procedure with regard to this legislation. There is no good explanation for this failure, but it may prove to be a very expensive oversight for the government.

The Whimsey case involves only tax returns for the tax year 1987, but there is some precedent, discussed by the Circuit Court, for the limited partnership to file amended returns for subsequent years as well. There has never been a federal revenue measure declared unconstitutional this long after its enactment, so there simply are no guidelines for taxpayers other than the plaintiff taxpayer in this litigation. Ordinarily, of course, legislation enacted in violation of the Constitution is totally void, and conceivable all taxpayers affected by the invalid tax measures conceivably could file amended returns.

Further, Whimsey has been handed down on the eve of tax filing deadlines for the 1996 tax year. Expect a flowering of tax mavens projecting appropriate strategy in tax protesting and tax reporting to "straddle" the risk of underpaying taxes owed and the possibility that the Supreme Court, on a certain appeal, will refuse to adopt the historic decision by the Court of Appeals.

Comment: The editor is as nonplussed as all the rest of DIRT readers concerning this case. In any event, he is burrowing busily into his own tax returns to identify what benefits might accrue if pre-1986 tax accounting rules applied to his real estate investments. He is far to busy to comment further on this case.

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