A taxpayer’s sale of his position in a lawsuit resulted in capital gain rather than ordinary income.
The Eleventh Circuit held that a real estate developer’s sale of his rights in a lawsuit regarding a land sale contract produced capital gain rather than ordinary income, reversing a holding of the Tax Court. According to the appellate court, the fact that the taxpayer had intended to sell the property in the ordinary course of his business was not dispositive in characterizing gain from sale of his contractual right to purchase it.
Facts: The developer, Philip Long, owned and operated Las Olas Tower Co. (LOTC) for the purpose of designing and constructing a high-rise luxury condominium building in Fort Lauderdale, Fla. In 2002, LOTC signed an agreement with Las Olas Riverside Hotel (LORH) obligating LORH to sell land to LOTC for $8,282,800 in 2004 that would be the future site of the condominiums. Before the closing date in 2004, LORH’s president died, and his heirs unilaterally terminated the sale agreement. Soon after, LOTC filed suit in Florida state court to compel LORH to sell the land, and in 2005, the court ordered LORH to sell the property to LOTC within 326 days—a decision appealed by LORH.
In 2006, while the lawsuit was on appeal, LOTC sold its position in the lawsuit for $5,750,000. Long reported $1,896,824 of the $5,750,000 proceeds on his 2006 Schedule C as ordinary income and did not report the remainder. After the IRS issued a notice of deficiency in 2010, Long petitioned the Tax Court for relief.
At trial, Long contended, among other arguments, that any taxable part of the $5,750,000 should be capital gain rather than ordinary income. The Tax Court held the entire $5,750,000 was ordinary income because the evidence—including Long’s advance sales and promotional activities, efforts to develop and improve the property, supervision and control over sales representatives, and status as a real estate professional—indicated that Long intended that the land subject to the purchase agreement would be property he held primarily for sale to customers in the ordinary course of business. Thus, absent the sale of rights in the lawsuit, Long would have earned future ordinary income. Long appealed the decision to the Eleventh Circuit.
Issues: Property is a capital asset unless it falls into one of the eight categories of noncapital assets listed in Sec. 1221(a) or the substitute-for-ordinary-income doctrine applies to the property. One of the types of assets listed in Sec. 1221(a) is property held primarily for sale to customers in the ordinary course of business—the type of property, according to the Tax Court, that Long had sold. Under the substitute-for-ordinary-income doctrine, a payment for property is treated as ordinary income (rather than capital gain income) if it is essentially a substitute for future ordinary income that the taxpayer would otherwise receive. The effect of the doctrine is to treat the property sold as a noncapital asset. The IRS argued that the substitute-for-ordinary-income doctrine applied to Long’s proceeds, and thus the lawsuit rights were not a capital asset. In the alternative, the IRS argued the proceeds from the sale of the lawsuit rights would be short-term capital gain because the sale occurred less than one year from the state court’s judgment ordering performance of the agreement.
Holding: The appellate court held that the Tax Court improperly treated the property sold by Long as the land itself rather than his right to purchase it and that the key question was whether Long intended to sell this right to customers in the ordinary course of business. The court found no evidence that this was the taxpayer’s intent. Therefore, the right was a capital asset. Furthermore, the court held that the substitute-for-ordinary-income doctrine did not apply. According to the court, the right sold by Long “represented the potential to earn income in the future based on the owner’s actions in using it,” and that selling a right to earn future undetermined income, as opposed to selling a right to earned income, is a key feature of a capital asset, and it did not matter that the future earned income would be ordinary income. The court also held that the capital gain was long-term since Long’s holding period began on the day he filed the lawsuit in 2004, well over a year before he sold his rights in the lawsuit. The court reversed the Tax Court’s decision that the gain was ordinary income and remanded the case to the Tax Court to redetermine Long’s tax liability.
By Charles J. Reichert, CPA , instructor of accounting, University of Minnesota–Duluth.