Chapter 21              p.1163
Future Income Streams

What is tax treatment (i.e., tax character) for a lump sum payment received in exchange for stream of future income from property?

Choices: 

(1)  Ordinary income, or

Capital proceeds - both (a) a return of capital investment (i.e., tax basis),  & (b) capital gain.

Further questions:  Timing? Immediately?

 

Prior Analysis:  Definition of a Capital Asset                       

§1221(a) defines the term “capital asset” as property held by the taxpayer (whether or not connected with his trade or business),

but does not include eight specified items: e.g., inventory; depreciable property (§1221(a)(2)); copyrights, etc.; accounts or notes receivable; supplies used in the ordinary course of business; and, certain other items. Note the impact of this categorization in the charitable contributions deductions context (§170(e).  

Depreciable Business & Real Property         

Is not a capital asset - §1221(a)(2).

But, if property is used in the trade or

business, see §1231(a)(3)(A)(i)) which can produce “§1231 gain.” 

Net §1231 gains are treated as long term

capital gains.  §1231(a)(1)(A).  Loss as ordinary.

But, if applicable gain is attributable to prior

depreciation, this deduction can be “recaptured”  as ordinary income.  §1245.

    

Ordinary Income Substitute? – Hort case        

Hort, p. 1163 – payment by a tenant for the cancellation of a real estate lease.   Ordinary income or cap. gain?  Taxpayer received payment for cancellation of a lease.  Property with lease was received from father’s estate.

Tenant payment of $140x for lease cancellation.

Owner claimed loss on the lease termination:  Loss of $21x-  Lease basis of $257,000 (unmatured rentals) less the future FMV rental for property.                                      continued

Ordinary Income Substitute? – Hort case        

IRS says entire payment is includible as ordinary income, i.e., merely a substitute for periodic rent and, therefore,  ordinary income?  Court agrees with IRS that all is ordinary income.  I.e., lease cancellation payment is only a substitute payment for termination of the future rental income stream.

Therefore, no capital gain treatment and no income tax basis offset (for this “carved out” interest). 

Premium Lease – see earlier – World Publishing

Can a lease have its own intrinsic value if it requires rental payments in excess of the current fair market value rent for the property?

What income tax treatment if purchasing a property with a “premium lease”?  Will additional consideration be paid for that property (assuming a creditworthy tenant)?

§167(c)(2) specifies no allocation of tax basis to a lease is permitted when property is acquired. Thus, only the physical property is depreciable.

McAllister v. Commr.
                                P.1166

Individual (widow) transfers her life interest in a testamentary trust to the remainderman for the receipt of a cash  payment. 

She reports a capital loss of $8,790 (the amount received less her income tax basis – established under the “uniform basis” rules). 

Is the amount received by her an accelerated payment of her anticipated income stream? 

Was this like the Blair case or the Hort case?

continued

McAllister v. Commr.
P.1166, continued

Held:  This was the sale by taxpayer of her entire property interest (capital) and was not the disposition of an income stream (treated as ord. income).  Correct result?  IRS acquieces.

But, what is the normal tax treatment to the life tenant?  All amounts received are treated as income (assuming not a principal distribution).

Consider:  Irwin v. Gavit (text p. 169) – all proceeds from gifted (15 year term) income interest are includible in gross income.

Considering McAlister: Tax Basis for Life Tenant?        

§1001(e) – Where life tenant sells his life interest the tax basis for the life interest is zero – unless the remainderman sells at the same time, in which situation the income tax basis is proportionately allocated.  However: capital gains treatment then to the selling life tenant.

Under “uniform basis” rules the original basis is allocated between (1) the life interest and (2) the remainder interest. Tax basis gradually shifted from life tenant, based on life expectancy tables.

Carved Out Oil Payments
P.G. Lake                p.1171

Corporation has a 7/8ths working interest in two oil and gas leases.  Corp. assigns a $600,000 oil payment (plus a 3% interest payment) to its president/creditor to pay a debt owed to him.

Cf., Old Colony  - payment deflection to IRS.

Corp. reported this transfer as a sale of property producing a $600,000 LTCG.

5th Circuit held: Assignment was a sale of a capital asset, i.e., an “interest in land” under local law. Right result?      See next slide.

Carved Out Oil Payments
P.G. Lake, continued

Supreme Court holds: 

Substance of the transaction is that the proceeds received were ordinary income (but, then subject to an oil/gas depletion deduction).

Consideration was paid for the right to receive future income.

Objective in this decision:  Prevent conversion of ordinary income into capital gain.

See next slide.

Oil Payments & Code §636                       p.1180

§636(a) – “carved-out production payment” – treated as a mortgage loan on the property (i.e., a payment periodically made by oil producer is made to the production payment holder on behalf of the seller).  This is not an economic interest to the recipient under a production payment, but to the “seller” (who gets the depletion deduction).  Taxed periodically when the royalty payments are actually made.

Oil Payments
& Code §636(b)     p.1180

ABC transactions:  Seller of oil property to a purchaser of property for FMV, but after reserving an oil payment (plus interest) which is paid from portion of net income from the lease.

§636(b) – Production payment is treated as a purchase money mortgage and as not qualifying as an economic interest in the mineral property.

Carter case             p.1181
Income Stream Payments

Corporation liquidates and distributes brokerage (commission) contracts having unascertainable value.   The liquidation event produces capital gain to the shareholder.

Taxpayer receives amounts under the contract & IRS says ordinary income treatment.

Remembering Burnet v. Logan re open transaction treatment:  Corporate liquidation was ongoing – (1) capital amounts were received and (2) on a deferred basis. 

Brown case            p.1185
Bootstrap sale

Taxpayer sells corporate stock to charitable organization –for $5,000 down and balance paid in ten years from profit of corporation.

Assets then leased back to an operating company controlled by the seller of the stock.

Operating company pays profits to charity as deductible rent.

Charity then pays (part of) rent to taxpayer as purchase price for the stock.

continued

Brown case            p.1185
Bootstrap sale, cont.

Was the sale “real” for tax purposes?

The risks of the business remained with the seller.

Sup. Ct. holds sale to be complete and amounts received produce capital gain.

Note:  Buyer was tax-exempt and therefore no corporate tax liability.

Subsequent:  §514 enacted, re unrelated income to charity from debt-financed property treated as ordinary business income.

 

Chapter 21

Chapter 21

Chapter 21