Arrowsmith v. Commissioner, 344 U.S. 6 (1952) (U.S. Supreme Court)
Arrowsmith v. Commissioner is a foundational Supreme Court case in federal income tax law that articulates a durable characterization principle: when a later payment or recovery is integrally connected to an earlier transaction, its tax character is determined by reference to that earlier transaction.
When former shareholders of a liquidated corporation later pay a judgment arising from the corporation's pre‑liquidation liability, must their resulting loss be characterized as a capital loss (by relation to the earlier liquidating distribution) or may it be treated as an ordinary loss in the year of payment?
A later payment (or recovery) that is integrally related to an earlier capital transaction takes its character from that transaction. Thus, when an event in a subsequent year is essentially a corrective or consequential adjustment to a prior capital transaction, the later gain or loss is characterized as capital rather than ordinary. Each tax year remains a separate accounting period, but character may be determined by reference to the origin and nature of the underlying transaction.
The payment made by the former shareholders in satisfaction of the liquidated corporation's pre‑liquidation liability must be treated as a capital loss because it relates back to the earlier liquidating distribution that produced capital gain.
Arrowsmith established a cornerstone of tax characterization: the tax character of subsequent, related payments or recoveries follows the character of the original transaction. The case is routinely cited to prevent taxpayers from converting capital items into ordinary deductions (or vice versa) by fragmenting a single economic transaction across tax years. It informs planning for liquidations, indemnities, escrows, contingent liabilities, and post-closing adjustments, and it interacts with doctrines like the tax benefit rule and the origin-of-the-claim test. For law students, Arrowsmith is essential for understanding how courts reconcile annual accounting with transactional consistency and how character flows through related events over time.