Maximize Capital Gain
In the sale of a business, it is the goal of every business owner and his tax adviser to minimize the amount of gain realized and, to the extent gain is realized, to maximize the amount that is treated as capital gain.
Property Used in Trade or Business
The gain realized on the sale or exchange of property used in a taxpayer’s trade or business is treated as capital gain. In general, the Code defines “property used in a trade or business” to include amortizable or depreciable property (subject to the so-called “recapture” rules), as well as real property, that has been used in a trade or business and has been held for more than one year.
If a property is not so described, the gain realized on its sale will generally be treated as ordinary income. Indeed, certain properties that are used in a business are explicitly excluded from capital gain treatment, including inventory and property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business (“inventory”).
Capital gain treatment may also result from the sale of a “capital asset.” This is generally defined to include property held by the taxpayer, whether or not it is connected with his trade or business, but not including “inventory,” “property used in a trade or business,” or accounts or notes receivable acquired in the ordinary course of a trade or business for services rendered or from the sale of “inventory.”
Contracts as Capital Asset?
Over the years, questions have arisen concerning the proper tax treatment of the gain realized by a business on the sale of certain contracts to which it is a party.
The courts have stated that not everything that can be called “property” under local law, and that is outside the statutory exclusions described above, qualifies as a capital asset; rather, according to the courts, the term “capital asset” should be construed narrowly in accordance with the purpose of Congress to afford capital gain treatment only in situations typically involving the realization of appreciation in value accrued over a substantial period of time.
Beyond these general, cautionary principles, it appears that the courts have not been able to clearly or consistently delineate between contracts that are capital assets and those that represent a right to income.
Thus, the courts have stated, at various times and in various contexts, that:
a capital asset requires something more than an opportunity, afforded by a contract, to obtain periodic receipts of income;
a taxpayer does not bring himself within capital gain treatment merely by showing that a contract constitutes “property,” that he held the contract for more than one year, and that the contract does not fall within any of the exclusions from the definition of capital asset;
the consideration received for the transfer of a contract right to receive income for the performance of personal services is taxable as ordinary income;
a lump-sum payment that is essentially a substitute for what would otherwise be received at a future time as ordinary income is consideration for the right to receive future income, not for an increase in the value of the income-producing property;
simply because the property transferred will produce ordinary income, and such income is a major factor in determining the value of the property, does not necessarily mean that the amount received in exchange for the property is essentially a lump-sum substitute for ordinary income;
contract rights may be a capital asset where they provide the possessor significant long-term benefits;
it is important to distinguish between proceeds from the present sale of the future right to earn income (capital gain) and the present sale of the future right to earned income (ordinary income).
Congress Provides Some Certainty
In many cases, taxpayers will have to consider the inconsistently applied criteria that have been developed by the courts in determining how the sale of a contract will be treated for tax purposes.
Thankfully, Congress has occasionally stepped in to clarify, at least somewhat, the tax treatment of the disposition of certain contract rights.
Sale of a Franchise
Taxpayer was formed in 1997 to bid on a request for proposal from County to take care of its waste/recycling needs. Taxpayer won a package of contracts that gave it the exclusive right to collect and dispose of County’s waste. The collection contracts started running in the summer of 1998 and ran through 2007, but could be extended by mutual agreement.
In 2002, a consultant for the waste industry asked Taxpayer if it would be willing to sell its business. It was, and that summer Taxpayer signed an agreement with the consultant, who put together a package that estimated potential sale prices. Things moved quickly and, by that fall, Taxpayer had signed a letter of intent to negotiate with the highest bidder.
In the fall of 2003, Taxpayer sold its assets, including its contracts with County, in an all-cash deal for $X million; there were no contingent payments. Taxpayer did not keep any interest in the contracts. The asset-purchase agreement allocated the purchase price among a covenant not to compete, tangible assets, buildings, land, intangibles, going concern value and goodwill.
Tax Return and Audit
On the Form 8594, Asset Acquisition Statement under Section 1060, filed with its 2003 tax return, Taxpayer reported the values of the assets sold the same way the parties allocated them in the asset-purchase agreement. The bulk of the purchase price was allocated to what Taxpayer reported as intangible assets (including the contracts) and going concern value/goodwill, to be taxed at as capital gain.
The IRS audited Taxpayer’s returns, and proposed an adjustment by re- characterizing as ordinary income the gain realized from the sale of Taxpayer’s contractual rights to provide waste-collection services to County. Taxpayer disagreed with the IRS, and filed a timely petition with the U.S. Tax Court.
Specifically, Taxpayer claimed that the contracts were franchises, and that their sale was covered by a statutory rule that taxed their sale at capital gain rates.
The IRS disagreed, stating that the Code provision relied upon by the Taxpayer did not apply, and urging the Court to apply the “substitute-for-ordinary-income” doctrine instead.
The Court began its discussion by analyzing the provision at issue. According to that provision, the sale of a franchise may not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest in the franchise transferred.
The first question to be addressed, the Court stated, was whether the contracts sold were “franchises” within the meaning of that provision. A “franchise” for the purposes of that provision, it continued, includes an agreement that gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area. The Court found that Taxpayer’s contracts were agreements to provide services within the County. Thus, they satisfied these requirements and came under the provision.
However, holding that the contracts were “franchises,” the Court noted, did not end the matter. The Court also had to determine whether Taxpayer kept any “significant power, right, or continuing interest” in the franchises; if it did, then its income from the sales would be ordinary (as if it had arisen under a license).
The Court found that Taxpayer did not retain any interest in the franchises/contracts, and that it did not receive any contingent payments; in fact, it received a single lump-sum payment.
Because the contracts qualified as franchises, and the Taxpayer neither kept any interests in the franchises nor received any contingent payments, the Court concluded that the sale transaction was not ineligible for capital gain treatment.
Taxpayer argued that this determination alone – not being ineligible for capital gain treatment – automatically entitled it to capital-gain treatment.
The Court pointed out, however, that the provision sets forth what does not get capital gain treatment; it does not specifically state that the sale of a franchise with respect to which the seller did not retain an interest automatically receives capital gain treatment.
According to the IRS, this meant that the provision was inapplicable by its own terms, covering only sales in which an interest in the franchise was retained by the seller. Thus, the IRS argued, the transactions were taxable as ordinary income.
The Court disagreed with the IRS. The provision, it stated, refers to capital accounts; specifically, any amount paid or incurred on account of a sale of a franchise, that is not deductible as an ordinary and necessary business expense by the acquiring-payor because it is not contingent upon the productivity or use of the franchise, is treated as an amount chargeable to capital account.
According to the Court, this implied that the sale of a franchise leads to capital gain treatment so long as the seller does not retain any significant interest in the franchise and the franchise was a capital asset.
Because Taxpayer kept no significant interest in the contracts sold, it was entitled to capital gain treatment on the gain realized from the sales.
I wish there was something beyond general principles on which to confidently rely in determining the tax treatment of the gain realized on the sale of a contract.
Some situations will obviously warrant capital gain treatment while others will obviously warrant ordinary income treatment. In between, there can be considerable uncertainty.
That being said, if the seller does not retain any interest in the contract (query how an earn-out will affect this), if the contract provides significant long-term benefits, if the contract involved a capital investment by the seller, and if the contract has some potential to appreciate in value over time, then the chance of capital gain treatment on the sale of the contract will be improved.
Of course, this analysis only goes to the nature of the gain. It does not necessarily influence the “structure”/terms of the contract, nor should it. The contract is a business arrangement, negotiated and entered into between two parties, each of which expects to profit from it currently, in the ordinary course of its trade or business, and not necessarily upon the disposition of the contract. Indeed, many contracts are not assignable, or are assignable only with the consent of the other party, in which case new contracts may just as likely be “re”-negotiated by the buyer.
It will nevertheless behoove the seller to understand and quantify the tax/economic cost of the sale of a contract, and to account for it in negotiating the price for the sale of the business. After all, it’s how much the seller keeps after taxes that matters.