Friday, September 30, 2016

A New Look at the Taxation of a Forfeited Deposit

William Delaney, EA
Westwood, MA
In CRI-Leslie, LLC v. Comm., 147 T.C. 8 (9/7/16) the Tax Court looked at the following fact pattern.  CRI (petitioner) executed a purchase and sale agreement with RPS, LLC to sell a hotel.  CRI received deposits from RPS in the total amount of $9,700,000, which were forfeited when the agreement “terminated in 2008 by its terms.”  The property did not transfer.

CRI reported the $9,700,000 as net long-term gain on its partnership 1065 tax return.  The IRS re-characterized the gain as subject to ordinary income tax and this interpretation of the Code was upheld by the Tax Court.

The parties stipulated to the Court that the hotel was “property used in a trade or business, as defined by section 1231(b)(1).  The parties further stipulated that “had CRI-Leslie sold the property in 2008 pursuant to the agreement’s terms, the gain from the sale would have resulted in net section 1231 gain…”  In a footnote, the Court noted that “Respondent (i.e. Comm. of  Revenue), however, does not stipulate that the $9,700,000 forfeited deposit is sec. 1231 gain.”

In Discussion, the Court noted that “Long-term capital ‘gain from the sale or exchange of a capital asset held for more than 1 year’.  Sec. 1222(3).”  Neither party disputes that statement.  Again, from the Discussion, “Under section 1221(a)(2) specifically, a capital asset is ‘property held by the taxpayer (whether or not connected with his trade or business), but does not include…property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business” (emphasis added).

Sec. 1234A.  Gain or losses from certain terminations (which is the controlling code section applicable to this case) reads as follows…

Gain or loss attributable to the cancellation, lapse, expiration or other termination of…

(1) a right or obligation…with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer…

shall be treated as gain or loss from the sale of a capital asset…

The Court noted that “There is no question that section 1234A extends rights or obligations relating to property that is described in section 1221(a)---that is, to capital assets.  However…section 1221(a)(2) excludes depreciable property used in the taxpayer’s trade or business as well as real property used in his trade or business.”

“The sole issue still in dispute (as stated by the Court) is whether ‘capital asset’ used in section 1234A extends to property described in section 1231.”

Turning to the petitioner’s argument, taxpayer maintains that it was the clear intent of the Congress to apply the Section 1234A taxation principle to capital gain property and not just to capital asset property.  If you have been able to follow the fact pattern, capital gain tax treatment was not allowed by the IRS under the theory [supported by reference to Code Section 1221(a)] that the forfeited deposit amount is not a capital asset as defined by Sec. 1234A.  The forfeited deposit, in the view of the IRS, falls outside of the definition of a capital asset.

The petitioner “urges us to consider congressional intent.”  By reference to United States v. Ron Pair Enters., Inc.,489 U.S. 235, 242 (1989), the petitioner argued “The plain meaning of legislation should be conclusive, except in the rare cases [in which] the literal application of a statute will produce a result demonstrably at odds with the drafters…In such cases, the intention of the drafters, rather than the strict language, controls.”  [as taken from Griffin v. Oceanic Contractors, inc., 458 U.S. 564, 571 (1982)].
Both are U.S. Supreme Court decisions.

Respondent (IRS) argued for a strict interpretation---“section 1234A expressly references a ‘capital asset in the hands of the taxpayer.’  Respondent cited several cases to support the strict interpretation argument.

The Court was then faced with resolving the meaning of capital asset.  The petitioner had conceded that the hotel property was not a capital asset within the meaning of Sec. 1221.  So, what was left to decide?  That the plain meaning of capital asset “as used in section 1234A does not extend to section 1231 property.”  The Court was unable to accept the argument that, in fairness, Congress never intended this to be the rule.  As the Court noted, “If Congress wished to extend section 1234A to section 1231 property, it has had 35 years to amend the statute.”  What is also relevant, in the opinion of your Editor, is that the Congress has reviewed/amended Section 1234A on at least four separate occasions, and its amendments/changes did not touch this area of law.

The Court concluded that “The clarity of congressional purpose in restricting the reach of the statute to capital assets is ineluctable.**  Accordingly, we hold that the plain meaning of the statute must govern here.”

Finally, the Court cited a number of cases interpreting Sec. 1234A to support its conclusion.

**Your Editor ran to his dictionary for the meaning of this new to him word.  It means inescapable.

Your Editor became aware of this case as a result of an on-line posting of a Forbes magazine contributing article.  The article noted that the case is one of “first impression” which means the first judicial look at a legal issue or interpretation of statute.  The first impression appears to be (to quote from the case) “…a novel argument…that Congress clearly intended for section 1234A to apply not only to payments received from contract terminations relating to capital assets but also to payments from terminations relating to section 1231 property.” (emphasis added).

The author concluded that the Tax Court got it wrong---its decision was incorrect and may be (make that should be) appealed.  From my reading of the case, I conclude otherwise.  The Court got it right.  Congressional intent that Section 1231 long-term capital gain treatment should apply is not supported by the record.

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