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Sale of Businesses Were Sales of Franchises; Gain Was Capital, Not Ordinary

(Parker Tax Publishing June 2017)

The Tax Court held that sales of municipal waste collection businesses by three related partnerships qualified as sales of franchises resulting in capital gains treatment. The contracts met the definition of franchises under Code Sec. 1253, and the partnerships neither retained any significant interests in the contracts after the sales nor received any contingent payments, so the transactions were not excluded from capital gains treatment under the statute. Greenteam v. Comm'r, T.C. Memo. 2017-122.


In 2003, three related California partnerships, Greenwaste of Tehama (Greenwaste), Greenteam of San Jose (Greenteam) and Greenteam Materials Recovery Facility (Greenteam Facility) sold their waste disposal and related businesses to Waste Collections, Inc. The partnerships sold substantially all of their assets, including their contracts, to Waste Collections in all-cash deals with no contingent payments. The partnerships did not keep any interest in the contracts.

The Greenwaste business included five contracts giving it the exclusive right to perform waste disposal and recycling services in Tehama County and in the city of Red Bluff. The fifth contract gave it the exclusive right to use the local landfill. As part of the landfill contract, Greenwaste agreed to pay for any needed improvements, although title to the improvements would revert to Tehama County and Red Bluff when the contract ended. The Greenwaste contracts began in 1998 and ran through June 2007, but could be extended by mutual agreement. The parties agreed that in 2003, the four Greenwaste collection contracts were collectively worth approximately $860,000, and the landfill contract was worth approximately $1 million.

Greenteam had entered into a similar contract for waste disposal and recycling services in San Jose. Greenteam made various improvements to San Jose's waste collection system, including installing radio frequency identification tags to every trash bin and outfitting its garbage trucks with computers to monitor collections. In order to process San Jose's recyclables, Greenteam formed Greenteam Facility to build a processing facility. The Greenteam and Greenteam Facility contracts ran through 1999, but could be extended up to three years. Green won the bid again when San Jose issued another request for proposal in 2000.

The IRS audited the Greenteam partnerships' 2003 returns in 2009 under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) and issued notices of final partnership administrative adjustment (FPAA) recharacterizing the gains from the sales of the contracts as ordinary income. The FPAA for Greenwaste recharacterized approximately $6,800,000 as ordinary income, Greenteam's FPAA recharacterized approximately $20,200,000 as ordinary income, and the Greenteam Facility FPAA recharacterized approximately $6,200,000 as ordinary income.


The partnerships petitioned the Tax Court and argued that the sales of the contracts fell under Code Sec. 1253, which provides that a taxpayer gets capital gains treatment when it sells a franchise unless it has a continuing interest in the franchise after the sale. The IRS contended that according to California industry standard, a contract to provide services for a limited time was a municipal contract, not a franchise, and that a franchise in California meant only a contract that continues to renew until it is terminated. It also interpreted Code Sec. 1253 to be inapplicable because the partnerships kept no interests in the contracts and did not receive any contingent payments. According to the IRS, since Code Sec. 1253 did not apply, the test for whether the contracts were capital assets had to be decided under Code Sec. 1221, the six part test under Foy v. Comm'r, 84 T.C. 50 (1985), and the substitute for ordinary income doctrine.

The Tax Court held that the contracts met the definition of franchises under Code Sec. 1253(b)(1) and that capital gains treatment applied to the sales. Under Code Sec. 1253, the sale of a franchise is not treated as the sale of a capital asset if the transferor retains any significant power, right or continuing interest. The Tax Court articulated the definition of a franchise under Code Sec. 1253(b)(1) as an agreement in which one party receives the right to provide services within a defined area. The contracts met the definition of a franchise under the statute because they were agreements to provide landfill, waste disposal and recycling services within the areas of Tehama County, Red Bluff, and San Jose, according to the Tax Court.

The Tax Court rejected the IRS's argument that the contracts could not be franchises because the industry standard was to refer to contracts for a limited time as municipal contracts. The relevant definition, in the Tax Court's view, was the one provided in Code Sec. 1253(b)(1). The Tax Court also rejected the IRS's argument that Code Sec. 1253 was inapplicable by its own terms, reasoning that the language of Code Sec. 1253(d) referring to capital accounts implied that the sale of a franchise leads to capital gains unless the transaction is specifically denied such treatment under Code Sec. 1253(a). The Tax Court further determined that previous decisions in the Tax Court and in the Fifth Circuit had reached the same conclusion and, moreover, that the legislative history of Code Sec 1253 confirmed the courts' interpretation.

Having found that the contracts were franchises, the Tax Court next determined that the partnerships did not keep any significant interests in the franchises or receive contingent payments. If any interests had been retained, the income from the sales would be ordinary under Code Sec. 1253(a). But because the partnerships retained no interests and received lump sum payments, the transactions were eligible for capital gains treatment under Code Sec. 1253.

The Tax Court concluded that Code Sec. 1253 applied to the transactions because the partnerships kept no significant interests in the contracts and that the partnerships were thus entitled to capital gains treatment on their profits. It therefore was not necessary for the court to decide whether the franchises were capital assets under Code Sec. 1221, Foy, or the substitute for ordinary income doctrine.

For a discussion of capital gains treatment for sales of franchises, see Parker Tax ¶117,115.

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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