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Tax Court Erred in Treating Sale of Interest in Litigation as Ordinary Income.
(Parker Tax Publishing December 8, 2014)

The Eleventh Circuit reversed the Tax Court, holding that a taxpayer's income from the sale of his interest in the outcome of a lawsuit was capital gain not ordinary income. Long v. Comm'r, 2014 PTC 577 (11th Cir. 2014).

Background

From 1994 to 2006, Philip Long owned and operated Las Olas Tower Company, Inc. (LOTC) as a sole proprietor. LOTC was created to design and build a luxury high-rise condominium called the Las Olas Tower on property owned by the Las Olas Riverside Hotel (LORH). To facilitate the building of the condominium, Long formed Alhambra Joint Ventures (AJV) with Steelervest, Inc. In November 2001, Steelervest purchased Long's interest in AJV (the AJV Agreement).

In 2002, Long, negotiating on behalf of LOTC, entered into an agreement with LORH (the Riverside Agreement) whereby LOTC agreed to buy land owned by LORH for $8,282,800 in order to build the condominium. LORH subsequently terminated the contract unilaterally. In March 2004, Long filed suit in Florida state court against LORH for specific performance of the contract and other damages. Long won at trial, and in November 2005, the state court ordered LORH to honor the Riverside Agreement and proceed with the sale of the land to LOTC. LORH appealed the judgment.

In August 2006, during the appeals process for the Riverside Agreement litigation, Steelervest and Long renegotiated the terms of the AJV Agreement, and, in a new agreement (the Amended AJV Agreement), Long agreed to pay Steelervest fifty percent of the first $1.75 million of monies received by Long as a result of the Riverside Agreement litigation. In September 2006, Long entered into an agreement with Louis Ferris, Jr. (the Assignment Agreement), whereby Long sold his position as plaintiff in the Riverside Agreement lawsuit to Ferris for $5,750,000.

For reasons unknown, Long filed a federal income tax return for 2006, reporting taxable income of $0. In 2010, the IRS served Long with a notice of deficiency indicating that he had taxable income of $4,145,423 and a tax liability of $1,430,743 in 2006. Long filed a pro se petition in the Tax Court seeking a redetermination.

The Tax Court, treating LORH's land as the putative capital asset, found that Long intended to sell the land to a developer. The court reasoned that the determination of whether it ultimately qualified for capital gain treatment depended on whether Long had intended to sell the land to customers in the ordinary course of his business. The Tax Court concluded that, while Long only intended to sell the land for the Las Olas Tower project, and not the individual condominium units themselves, the $5.75 million payment for Long's position in the lawsuit nevertheless constituted ordinary income because Long intended to sell the land to customers in the ordinary course of his business. Long appealed to the Eleventh Circuit.

Appeal and Analysis

The primary issue before the circuit court was whether the tax court erred in characterizing the gain as ordinary income. An important secondary issue was whether any gain was short- or long-term.

In support of his position that the $5.75 million he received from the Assignment Agreement should be taxed as a long-term capital gain, Long noted that he only had an option to purchase LORH's land, and the only asset he ever had in the Las Olas Tower project was the Riverside Agreement.

In response, the IRS argued that Long's proceeds from the Assignment Agreement were not a capital gain, but rather a lump sum substitution for the ordinary income he would have earned from developing the Las Olas Tower project. Thus, under the "substitute for ordinary income doctrine," the $5.75 million lump sum payment was taxable as ordinary income. The IRS also argued that the $5.75 million, which constitutes Long's proceeds from the sale of his judgment, is a short-term gain, because Long sold the judgment to Ferris on September 13, 2006, less than a year after the court entered judgment on November 21, 2005.

Income representing proceeds from the sale or exchange of a capital asset that a taxpayer holds for over a year is considered a capital gain and is taxed at a favorable rate. Womack v. Comm'r, 510 F.3d 1295 (11th Cir. 2007). "Capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. Code Sec. 1221(a)(1). In certain circumstances, contract rights may be capital assets. Pounds v. United States, 372 F.2d 342 (5th Cir. 1967).

The Circuit Court held the Tax Court erred by misconstruing the "property" subject to capital gains analysis under Code Sec. 1221. The Tax Court analyzed the capital gains issue as if the land subject to the Riverside Agreement was the "property" that Long disposed of for in return for $5.75 million. However, the Circuit Court noted that Long never actually owned the land, and, instead, sold a judgment giving the exclusive right to purchase LORH's land pursuant to the terms of the Riverside Agreement. The court determined Long did not sell the land itself, but rather his right to purchase the land, which was a distinct contractual right and potentially a capital asset. Thus, the "property" subject to the capital gains analysis was really Long's exclusive right to purchase the property pursuant to the Florida court judgment.

The Circuit Court also rejected the IRS's argument that the gain was short-term. The court noted that if the asset subject to capital gains treatment was an assignment of litigation rights, then Long acquired the asset when he filed suit in March of 2004, not when he obtained the judgment. The court further opined that the real asset at issue was Long's exclusive right to purchase the land, which he obtained pursuant to his execution of the Riverside Agreement in 2002, well over the one-year period required for long-term capital gains treatment.

Accordingly, the Circuit Court held that the profit from the $5.75 million Long received in the sale of his position in the Riverside Agreement lawsuit was more appropriately characterized as a long-term capital gain. The ruling of the Tax Court was reversed and remanded with instructions to determine Long's new tax liability.

For a discussion of capital assets, see Parker Tax ¶111,105. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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