In Uncategorized on 08/06/2013 at 15:54

No, not Karl Marx’s 1867 assault on Truth, Justice and The American Way, but rather a couple of designated hitters by The Great Dissenter, Judge Mark V. Holmes, a/k/a The Judge Who Writes Like a Human Being, who sets out a schema for determining when a contract right is a capital asset (and therefore favorably taxed at capital gains rates when sold) or merely a funnel for ordinary income (in which case it is taxed as such when sold).

This useful refresher is found in Greenteam Materials Recovery Facility PN; Greenwaste Recovery, Inc., Tax Matters Partner, et al., Docket No. 21946-09, and its companion Greenwaste Of Tehama, PN, Zanker Road Resource Management, Ltd., A California Limited Partnership, Tax Matters Partner, Docket No 423-11, both filed 8/6/13.

The Greens sold their assets, which mostly consisted of service contracts to deal with various California municipalities’ waste, to unrelated third parties, and claimed the contracts were capital assets. IRS said no, served FPAAs, and the Greens move for summary judgment.

Of course, the Greens’ tax returns for the year in question never made it into the record, but the Greens claimed in their motion the numbers on the returns were wrong anyway, and supplied new ones. And the contracts never made it into the record either.

So there are enough fact questions to deny summary judgment off the bat, but Judge Holmes has something to say about capital assets.

“When does a sale of rights under a contract create capital gain and when does it create only ordinary income? The Code tells us that capital gain is derived from the sale or exchange of a capital asset. Section 1221 defines a capital asset as ‘property held by the taxpayer.’ (There are exceptions, but none apply here.) But caselaw has made clear that the list of statutory exceptions is not exhaustive, and there are scores, perhaps hundreds, of cases that try to draw clear lines in this especially fuzzy area — none of which petitioner cites. Still, our own research in the area cannot improve on Judge Friendly’s summary of the problem a half century ago:

[I]t has long been settled that a taxpayer does not bring himself within the capital gains provision merely by fulfilling the simple syllogism that a contract normally constitutes ‘property,’ that he held a contract, and that his contract does not fall within a specified exclusion * * *

[I]t would be hard to think of a contract more ‘naked’ than a debenture, yet no one doubts that is a ‘capital asset’ if held by an investor. Efforts to frame a universal negative, e.g., that a transaction can never qualify if the taxpayer has merely collapsed anticipation of future income, are equally fruitless; a lessor’s sale of his interest in a 999 year net lease and an investor’s sale of a perpetual bond sufficiently illustrate why * * *

* * * * * * *

One common characteristic of the group held to come within the capital gain provision is that the taxpayer had either what might be called an ‘estate’ in * * *, or an ‘encumbrance’ on * * *, or an option to acquire an interest in * * *, property which, if itself held, would be a capital asset. In all these cases the taxpayer had something more than an opportunity, afforded by contract, to obtain periodic receipts of income, by dealing with another * * *Commissioner v. Ferrer, 304 F.2d 125, 129-30 (2d Cir. 1962) (emphasis added) (citations omitted), rev’g 35 T.C. 617 (1961).” Order in Docket No. 21946-09, at pp. 3-4.

Judge Holmes goes on: “The lines are not bright in this area. In a very similar case, Foy v. Commissioner,84 T.C. 50, 69-70 (1985), we held that in determining whether the taxpayer’s contract rights that were transferred constituted a capital asset, courts generally consider all aspects of the bundle of rights and responsibilities of the taxpayer that were transferred, specifically including the following six factors:

(1) How the contract rights originated;

(2) How the contract rights were acquired;

(3) Whether the contract rights represented an equitable interest in property which itself constituted a capital asset;

(4) Whether the transfer of contract rights merely substituted the source from which the taxpayer otherwise would have received ordinary mcome;

(5) Whether significant investment risks were associated with the contract rights and, if so, whether they were included in the transfer; and

(6) Whether the contract rights primarily represented compensation for personal services.” Order in Docket No. 21946-09, at p. 5-6.

All the Greens claim is that revenue under the contracts wasn’t guaranteed, but that doesn’t make them capital assets, any more than any of us has capital gains on the pittances we finally collect, because it’s not certain that our clients will pay us (and you can say that again!).

And in Docket No. 423-11, the Greens argue that their allocation of items in the contract of sale must be respected, but that’s a total nonstarter. “The Court also agrees with the Commissioner that Greenwaste of Tehama’s seems to argue that the Commissioner must respect the allocation of the purchase price that it and Waste Connections may have agreed to. We rejected this very proposition years ago. (And both parties must be prepared, if they do not settle this case, to become conversant in the numerous conflicting lines of caselaw on this question.).” Order at Docket No. 423-11, at p. 3. (Citations omitted, but read them. And see my blogpost “Buying Trouble”, 1/18/12, for another look at the allocation question).

So guys, hit the books, or the internet, and do your homework.

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