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Partnership Not Entitled to Capital Gain Treatment on Forfeited Deposit

(Parker Tax Publishing September 2016)

The Tax Court held that, where a partnership received as income a $9.7 million deposit forfeited by a prospective buyer of its hotel when the deal fell through, the deposit was taxable as ordinary income. The court rejected the partnership's argument that, under Code Sec. 1234A, the income was capital gain because the sale of the hotel would have been treated as capital gain under Code Sec. 1231. CRI-Leslie, LLC v. Comm'r, 147 T.C. No. 8 (2016).


In 2005, CRI-Leslie, a partnership, purchased the Radisson Bay Harbor Hotel in Tampa, Florida. The property consisted of both land and improvements thereon. The improvements included the hotel, a restaurant, a swimming pool, a parking lot, and landscaping.

In 2006, CRI-Leslie agreed to sell the hotel to RPS, LLC. Under a purchase and sale agreement, CRI-Leslie agreed to sell the property to RPS, LLC for $39 million. RPS, LLC put down a nonrefundable deposit of $9.7 million in connection with the agreement. The deposit was to be applied to the property's purchase price at closing. The agreement was revised and amended several times over the next two years, including an increase in the property's purchase price to $39.2 million. RPS, LLC, defaulted on the agreement in 2008. CRI-Leslie kept the $9.7 million and reported the deposit income as net long-term capital gain on its 2008 partnership income tax return. The IRS rejected that characterization and assessed a deficiency based on its determination that the $9.7 million deposit was ordinary income to the partnership.

Code Sec. 1221(a)(2) excludes depreciable property used in the taxpayer's trade or business, as well as real property used in a trade or business, from the definition of a capital asset. CRI-Leslie and the IRS agreed that the property at issue was real property used in CRI-Leslie's hotel and restaurant business, meaning that it fell within Code Sec. 1221(a)(2) and was therefore not a capital asset under Code Sec. 1221(a). However, the parties agreed that the property was properly classified under Code Sec. 1231(b)(1) as property used in the trade or business of CRI-Leslie. Had CRI-Leslie sold the property in 2008, the gain from the sale would have resulted in Code Sec. 1231 gain, which would have been treated as long-term capital gain under Code Sec. 1231(a)(1).

Tax Treatment of Gains and Losses from Terminations of Certain Contractual Rights

Code Sec. 1234A addresses the tax treatment of gains or losses from terminations of certain contractual rights. It provides that a gain or loss attributable to the cancellation, lapse, expiration, or other termination of certain rights, obligations, or contracts is treated as a capital gain or loss. The provision applies to (1) a right or obligation (other than a securities futures contract, as defined in Code Sec. 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or (2) a Code Sec. 1256 contract not described in (1) which is a capital asset in the hands of the taxpayer. The IRS has not issued any final regulations under Code Sec. 1234A.

Issue of First Impression Before the Tax Court

The Tax Court stated that the issue before it was one of first impression: whether CRI-Leslie was entitled to capital gain treatment under Code Sec. 1234A for its right to retain the forfeited $9.7 million deposit from a canceled sale of real property used in its trade or business, where such sale would have generated a capital gain. The court noted that while Code Sec. 1234A extends to rights or obligations relating to capital assets, Code Sec. 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, from the definition of a capital asset.

Partnership's Position

According to CRI-Leslie, Congress enacted Code Sec. 1234A to ensure that taxpayers received the same tax characterization of gain or loss whether the property is sold, or the contract to which the property is subject, is terminated. It is inconsistent to treat termination payments on a contract as ordinary income, the partnership contended, where a sale of the underlying property would have been taxed at capital gain rates.

CRI-Leslie argued that there is an inherent ambiguity in the apparent meaning of Code Sec. 1234A and urged the Tax Court to look at congressional intent behind the enactment of Code Sec. 1234A. The partnership cited a related Senate Committee Report and said that, even if the statute is unambiguous, the legislative history was clearly contrary to the statute's plain meaning.

IRS's Position

The IRS urged the Tax Court to interpret Code Sec. 1234A narrowly and look no further than the statute's plain and unambiguous wording. Code Sec. 1234A expressly references a "capital asset in the hands of the taxpayer," the IRS noted, and since the Radisson Bay Harbor Hotel was Code Sec. 1231 property, it was not a capital asset as defined in Code Sec. 1221 and thus did not fall under Code Sec. 1234A.

The IRS cited case law requiring federal courts to give effect to congressional intent that is made clear in a statute, noting that congressional intent is to be discerned primarily from the statutory text. The IRS further noted that by the time Congress enacted Code Sec. 1234A in 1981, the separate definitions of "capital asset" and "property used in the taxpayer's trade or business" were already firmly established in the Code. Since Congress presumably enacts legislation with knowledge of the law, the IRS said, a newly enacted statute is presumed to be harmonious with existing law and judicial concepts.

Tax Court's Decision

The Tax Court held that CRI-Leslie was not entitled to capital gain treatment on the forfeited deposit. Code Sec. 1234A, the court said, applies only to capital assets, not Code Sec. 1231 property.

In reaching its decision, the Tax Court noted that it had recently examined Code Sec. 1234A in Pilgrim's Pride Corp. v. Comm'r, 141 T.C. 533 (2013). While noting that the issue in Pilgrim's Pride was a different issue than in the instant case, the Tax Court said its analysis of the statute's purpose remained unchanged: Congress originally enacted Code Sec. 1234A to combat straddles and other transactions exploited by tax shelter promoters and, in 1997, extended the statute's application to all types of property that are (or on acquisition would be) capital assets in the hands of the taxpayer. The Tax Court noted that the Fifth Circuit reversed its ultimate decision in Pilgrim's Pride and held that Code Sec. 1234A applied to the abandonment of rights or obligations with respect to capital assets but not to the abandonment of the assets themselves. However, the Tax Court observed, the Fifth Circuit did not dispute the Tax Court's interpretation of the legislative purpose underlying the enactment of Code Sec. 1234A. The Fifth Circuit further reiterated the understanding underlying the entire body of Code Sec. 1234A law; that by its plain terms, Code Sec. 1234A(1) applies to the termination of rights or obligations with respect to capital assets (e.g. derivative or contractual rights to buy or sell capital assets).

In conclusion, the Tax Court rejected the partnership's argument that the tax treatment allowed under Code Sec. 1234A should be extended to Code Sec. 1231 property, saying that it would instead defer to the will of Congress as manifested in the text of the statute.

For a discussion of Code Sec. 1234A and the tax treatment of gains and losses on the termination of certain contracts, see Parker Tax ¶116,130.

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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