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Capital vs. Ordinary Federal Income Tax Tax

Sale of Long-Term Service Contracts: Capital or Ordinary Gain?

If a taxpayer sells a business that owns long-term service contracts, is the gain attributable to the contracts subject to tax at ordinary or capital gains rates? The IRS’s recent action on decision for the Greenteam Materials Recovery Facility PN v. Commissioner, T.C. Memo. 2017-122 court case deals with this in the context of a sale of a trash removal business that had long-term contracts to remove trash.

Facts & Procedural History

We previously covered this case for the limited context of how the court defined the term “franchise.” You can read that post here. That post didn’t go into the facts as they weren’t relevant to the issue addressed in the post.

The facts in the case can be summarized as follows: the taxpayer was a California partnership. It was a trash collecting business. It had long term contracts, which as noted in the prior posts, qualify as franchises for tax purposes.

The business was sold to a third party. The deal was structured as an asset sale. The taxpayer took the position that the gain attributable to the contracts or franchises was capital in nature. The IRS argued that the gain was ordinary in nature.

The court concluded that the gain was capital in nature, which resulted in the IRS publishing its Action on Decision to note its non-acquiescence in the case. This is likely a warning to tax planning attorneys that the IRS will challenge this in the future. Returns that report capital gains would fall into the category of problem tax returns.

About Asset Sales Generally

Most business sales are structured as asset sales. This is largely driven by the fact that the buyer has the cash and can set the terms.

Buyers like asset sales as they generally get higher tax basis in the assets that can result in larger depreciation deductions. This is particularly true now, given that used property can qualify for 100% bonus depreciation.

Buyers also demand asset sales to avoid hidden or unknown liabilities that the former business may have.

When a business is sold as an asset sale, the parties generally have to agree on how to allocate the gain among the assets. They can do this by including an allocation in the deal documents. Absent an allocation, the parties may include a general “we’ll agree later” type of term in the agreement. The rules set out several categories of assets and how the gain is to be allocated. Goodwill is the last catch-all asset category where gain in excess of other types of property is allocated, for example.

Once the gain is allocated, one can determine whether the gain is ordinary or capital. This brings us back to the Greenteam case.

The Court Says Franchises are Capital Assets

Gain is taxed at capital gains rates if the asset is a capital asset. Section 1221 provides a definition of what types of property are capital assets. The definition is actually a list of what is not a capital asset. This list does not address franchises or long-term service contracts.

Section 1253 does address the sale of franchises. It is also stated in the negative, meaning, it says when a sale of a franchise is not treated as a capital asset. The implication is that a franchise does not meet the requirements of Section 1253, then it should be accorded capital gain treatment.

In this case, the taxpayer argued that the franchises did not meet the requirements of Section 1253 and, by implication, were capital assets. The court agreed.

The IRS Says Franchises are Not Capital Assets

The IRS argued that Section 1253 did not apply, as Section 1253 was not triggered given that the taxpayer did not meet the requirements of Section 1253. According to the IRS, since Section 1253 did not apply, the court only had to look to Section 1221 to decide the case. With respect to Section 1221, the IRS argued that the franchises were not capital assets.

The IRS cited the multi-factor test of Foy v. Commissioner, 84 T.C. 50 (1985) and the substitute-for-ordinary-income doctrine. According to the IRS, these rules result in the franchises not being capital assets as defined in Section 1221. The trial court did not get into these arguments as it concluded that Section 1253 goverened and the taxpayer won under that Code section.

The IRS’s action on decision notes the IRS’s disagreement with the trial court’s conclusion. It also notes that the IRS intends to litigate this issue in future cases. This serves to remind taxpayers who sell businesses that have long-term contracts that they should consider this issue when reporting the gain from the sale of their businesses.

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