Baker v. U.S.

• Citation: 748 F.2d 1465
• Decision Date: 03 December 1984
• Docket Number: No. 84-8036,84-8036
• Parties: -509, 85-1 USTC P 9101 Willard K. BAKER and Irene L. Baker, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Eleventh Circuit

Page 1465

748 F.2d 1465

55 A.F.T.R.2d 85-509, 85-1 USTC P 9101

Willard K. BAKER and Irene L. Baker, Plaintiffs-Appellees, v. UNITED STATES of America, Defendant-Appellant.

No. 84-8036.

United States Court of Appeals Eleventh Circuit.

Dec. 3, 1984.

Glenn L. Archer, Asst. Atty. Gen., Gilbert S. Rothenbergrass, Laurie A. Synder, Tax Div., Dept. of Justice, Washington, D.C., for defendant-appellant.

William E. Frantz, Atlanta, Ga., for plaintiffs-appellees.

Appeal from the United States District Court for the Northern District of Georgia.

Before KRAVITCH and HENDERSON, Circuit Judges, and ALLGOOD ^*, District Judge.

KRAVITCH, Circuit Judge:

The Internal Revenue Service (IRS) has determined that veterans enrolled in flight-training courses may not deduct from taxable income that portion of their tuition reimbursed by tax-exempt Veterans Benefits. In this case we must decide whether the IRS abused its discretion by applying this ruling to previous tax years. The United States appeals from the district court's determination that the Service should not have disallowed retroactively a deduction for educational expenses taken in 1977 by the appellees, Willard and Irene Baker. We affirm.

I. BACKGROUND

In 1977, Willard Baker attended flight-training classes in Atlanta, which cost $10,384. At the time, Baker was employed as a Delta Airlines pilot. The Bakers, on their joint return for 1977, reduced their taxable income by the cost of the class, claiming that amount as a trade or business deduction. 26 U.S.C. Sec. 162(a) (1982). Because Willard Baker had served in the armed forces, the Veterans Administration (VA) in 1977 paid him $9,345 as an educational assistance allowance under former 38 U.S.C. Sec. 1677(b) (repealed 1981). This amount is statutorily exempt from taxation. 38 U.S.C. Sec. 3101(a) (1982). Although Baker was in effect reimbursed for ninety percent of the tuition, he was permitted to deduct the entire amount he expended pursuant to a 1962 revenue ruling, in which the IRS stated that a deduction for educational expenses need not be reduced by the amount of educational benefits paid by the VA. Rev.Rul. 62-213, 1962-2 C.B.50, revoked by, Rev.Rul. 83-3, 1983-1 I.R.B.10.

In 1980 the IRS modified its prior ruling and determined that flight-training expenses would not be deductible to the extent that a taxpayer receives tax-exempt educational benefits from the VA under former 38 U.S.C. Sec. 1677(b). Rev.Rul. 80-173, 1980-2 C.B.60. The IRS reasoned that 26 U.S.C. Sec. 162(a) did not permit deduction of an expense for which a taxpayer specifically is reimbursed. With respect to all other VA educational benefits, the Commissioner left his prior ruling intact. The Commissioner distinguished flight-training allowances from payments made for other educational programs, characterizing the former as a tuition reimbursement and the latter as a living stipend consisting of a level payment made without consideration of the costs incurred. Because the Commissioner did not indicate that this new ruling would be prospective only, the decision was presumed to be retroactive under 26 U.S.C. Sec. 7805(b) (1982). Subsequently, the IRS reversed its previously held position as to general educational benefits, ruling that no veteran may deduct amounts expended for educational programs that are allocable to tax-free benefits paid by the VA. Rev. Rul. 83-3, 1983-1 I.R.B.10. This later ruling, however, was limited to prospective application only.

The IRS audited appellees' 1977 return, reduced their deduction by the amount received from the VA, and assessed a deficiency of $4,525. On December 30, 1981, appellees paid this amount. After the Commissioner denied their claim for refund, appellees instituted this suit in district court. On cross-motions for summary judgment, ¹ the court ruled that plaintiffs were entitled to the refund because the IRS had abused its discretion by retroactively denying a deduction to taxpayers who received educational benefits for flight-training courses while not disallowing the same deduction for those whose entitlement to benefits accrued by reason of their enrollment in other forms of education. Baker v. United States, 575 F.Supp. 508 (N.D.Ga.1983). The United States now brings this appeal. ²

II. DISCUSSION

The government argues that Congress has expressly permitted the IRS to apply its decisions retroactively. Section 7805(b) of the Internal Revenue Code provides that the "Secretary may prescribe the extent, if any, to which any ruling or regulation, relating to the Internal Revenue laws, shall be applied with retroactive effect." 26 U.S.C. Sec. 7805(b) (1982). Unless otherwise indicated, IRS rulings and regulations therefore are presumed to be retroactive. See Anderson, Clayton & Co. v. United States, 562 F.2d 972, 979 (5th Cir.1977), cert. denied, 436 U.S. 944, 98 S.Ct. 2845, 56 L.Ed.2d 785 (1978). ³ Failure to limit rulings to prospective application, however, is reviewable for an abuse of discretion. See Dixon v. United States, 381 U.S. 68, 71-75, 85 S.Ct. 1301, 1303-05, 14 L.Ed.2d 223 (1965); Wendland v. Commissioner, 739 F.2d 580, 581 (11th Cir.1984). Thus, although retroactivity is presumptively permissible, in each case the reviewing court must determine whether under all the circumstances, retroactive application is warranted. Chock Full O'Nuts Corp. v. United States, 453 F.2d 300, 302-03 (2d Cir.1971).

In Anderson, Clayton, the former Fifth Circuit delineated certain relevant factors for a court to consider when reviewing the Commissioner's decision to apply a ruling retroactively.

(1) [W]hether or to what extent the taxpayer justifiably relied on settled prior law or policy and whether or to what extent the putatively retroactive regulation alters that law; (2) the extent, if any, to which the prior law or policy has been implicitly approved by Congress, as by legislative reenactment of the pertinent Code provisions; (3) whether retroactivity would advance or frustrate the interest in equality of treatment among similarly situated taxpayers; and (4) whether according retroactive effect would produce an inordinately harsh result.

562 F.2d at 981. Appellees' arguments focus on the third factor, the equality of treatment among similarly situated taxpayers. As Justice Frankfurter observed:

The Commissioner cannot tax one and not tax another without some rational basis for the difference. And so, assuming the correctness of the principle of "equality," it can be an independent ground of the decision that the Commissioner has been inconsistent, without much concern for whether we should hold as an original matter that the position the Commissioner now seeks to sustain is wrong.

United States v. Kaiser, 363 U.S. 299, 308, 80 S.Ct. 1204, 1210, 4 L.Ed.2d 1233 (1960) (concurring opinion).

Although this principle has not often been invoked to overturn the Commissioner's decision to create a retroactive ruling, courts have held that retroactive decisions that result in inequality of treatment unexplained by any rational basis can indeed constitute an abuse of discretion. For example, in Exchange Parts Co. v. United States, 150 Ct.Cl. 538, 279 F.2d 251 (1960), the court held that the Commissioner's decision to apply a ruling retroactively for some taxpayers and prospectively for others was impermissible. Exchange Parts arose when plaintiff sought to recover a manufacturers' excise tax that it had paid for many years upon the sale of its products. In its request for a refund, plaintiff relied on two letter rulings and two revenue rulings in which the IRS held that plaintiff's products were exempt from the tax. After plaintiff filed for a refund, the IRS reversed its position on the issue. In revoking its previous rulings, the IRS stated that it would not seek to recover unpaid taxes for parts already sold. It would not, however, refund taxes that had been paid. The court held the Commissioner's distinction, based solely upon whether the tax was collected, to be discriminatory and ordered a refund. Id. at 254. Other courts, when faced with similar arbitrary distinctions, have forbidden the IRS to apply rulings retroactively. See Farmers' and Merchants' Bank v. United States, 476 F.2d 406 (4th Cir.1973); Connecticut Railway and Lighting Co. v. United States, 135 Ct.Cl. 650, 142 F.Supp. 907 (1956).

The government contends that the difference in the methods used to compute the benefits for flight-training courses and other forms of education provides a rational basis for differential tax treatment of the two. Former 38 U.S.C. Sec. 1677(b), entitled a veteran enrolled in a flight-training program to receive ninety percent of the tuition as an educational benefit. On the other hand, under 38 U.S.C. Sec. 1682(a)(1) (1982), general educational benefits are computed based upon the number of the veteran's dependents and the degree of participation in a course. Thus, the government argues, the former is a direct reimbursement of money expended; the latter is a living stipend awarded without consideration of the amount of educational expenses incurred. ⁴ Indeed, in Manocchio v. Commissioner, 710 F.2d 1400 (9th Cir.1983), a case factually indistinguishable from the one at bar, the Ninth Circuit employed this very distinction when it approved the retroactive application of the revenue ruling before us. 710 F.2d at 1404. ⁵ We disagree with the Manocchio court's conclusion that the distinct methods of determining benefits justify the disparate treatment of taxpayers.

An analysis of the applicable statutory scheme assists us in the resolution of this case, and reveals that Congress created but one educational assistance allowance, the recipients of which should be afforded similar treatment for tax purposes. Congress's purpose in enacting the system of VA payments to veterans enrolled in educational programs was to encourage individuals to enlist in the armed services and to aid veterans who...