State Income Tax Credit Is a Capital Asset
The Tax Court held that a taxpayer’s sale of a state income tax credit resulted in a capital gain, not ordinary income, since the payments received from the sale were not a substitute for ordinary income.
Capital assets consist of all assets except those listed in eight categories in IRC § 1221(a). Common noncapital assets are inventory, accounts and notes receivable, depreciable property and land used in a trade or business, and supplies. Certain copyrights, U.S. government publications, commodities derivative instruments and hedging transactions are also excluded as capital assets. In addition to the eight statutory exclusions, the courts have held that the right to receive future ordinary income is not a capital asset.
In 2004, George and Georgetta Tempel, residents of Colorado, made a charitable donation of a qualified conservation easement and thereby qualified under Colorado law for $260,000 in state conservation donation income tax credits. The credits made the Tempels eligible for a limited Colorado state income tax refund. The couple also was permitted under Colorado law to carry unused credits forward up to 20 years, or they could transfer any unused credits to certain other taxpayers. In December 2004, the Tempels sold $110,000 of tax credits, receiving net proceeds of $82,500. On their federal joint return, after assigning a basis of $4,897 (a portion of the professional fees incurred to make the donation) to the tax credits, the Tempels reported a short-term capital gain of $77,603 on their 2004 return. The IRS issued a deficiency notice for 2004 and 2005 reclassifying the entire proceeds as ordinary income and assigning a zero basis to the credits. The taxpayers petitioned the Tax Court for relief. In a cross-motion to the government’s motion for summary judgment, the Tempels claimed the gain should be long-term capital gain and that a portion of the land’s cost could be allocated to the state credits as basis.
The IRS conceded that the income tax credits did not fall under any of the eight statutory exceptions but rather argued there was a sale of contract rights that should be analyzed using the six-factor test of Gladden v. Commissioner (112 TC 209). The court held the Gladden factors were inapplicable to this case because government-granted tax credits are not contract rights.
The IRS further argued the Tempels had the equivalent of economic income when they sold their state tax credits, because their future federal tax liability was lower due to higher future itemized deductions for state income taxes. The court held that a lower tax liability is not an accession of wealth and cannot be income. Furthermore, the Tempels’ receipt of the credits was not a right to income, and therefore they did not sell a right to earned income or to earn income. Thus the proceeds could not be a substitute for the right to receive future ordinary income, according to the court.
The court agreed with the IRS, however, that the Tempels’ basis in the credits was zero. It held that none of the expenses related to the donation should be assigned as basis of the credits, since the taxpayers did not acquire them by purchase but received them by complying with a state tax law. Furthermore, none of the basis in their land could be assigned to the credits that were sold, because the credits were not a property right in the land they owned. On similar grounds, the court also rejected the taxpayers’ argument that their holding period in the land upon which the conservation easement was based should carry over to the credits and held that their gain was therefore short-term.
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.
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