Appeals Court Decision Overturned Tax Court Ruling: Redetermination of Taxable Ordinary Income to Long-Term Capital Gains – Philip Long vs. Commissioner

Appeals Court Decision Overturned Tax Court Ruling: Redetermination of Taxable Ordinary Income to Long-Term Capital Gains – Philip Long vs. Commissioner

History

From 1994 to 2006, Philip Long was the sole proprietor of Las Olas Tower Company, Inc., which was formed to design and build a luxury high-rise condominium on property owned by a hotel. Long reported his annual income on Schedule C of his personal tax return.

From 1997 to 2003, Long also owned Alhambra Brothers, Inc., which was formed to build a different luxury condominium in Ft. Lauderdale, Florida. To facilitate this project, he formed a joint venture with Steelervest, an unrelated entity.

In 1995, Steelervest loaned funds to Long’s original company, Las Olas. In 2001, Steelervest purchased Long’s portion of the joint venture from Alhambra Brothers (AJV agreement). As part of this deal, Steelervest forgave the loans to Las Olas and Long agreed to pay Steelervest $600K if he sold his interest in the original project.

In 2002, Las Olas entered into an agreement with the hotel to buy land, which the hotel subsequently terminated. In 2004, Las Olas sued the hotel for specific performance and won. The hotel appealed the judgment. In August 2006, during the appeals process, Steelervest and Long renegotiated the terms of the joint venture agreement, and in a new agreement, Long agreed to pay Steelervest 50% of the first $1.75M received as a result of the litigation. In September 2006, Long sold his position as plaintiff in the lawsuit for $5.75M. Steelervest was entitled to $875K but agreed to receive only $600K.

Issues of this case

• Tax treatment of the $600K payment to Steelervest
• Tax treatment of the $5.75M received as a result of the litigation
• Deductibility of unsubstantiated accounting fees (not addressed in this article)

$600K payment to Steelervest

Long presented the $600K payment as a deductible expense on his tax return. The IRS originally determined that the payment did not qualify as a deductible expense, but was essentially a debt repayment. In tax court, Long argued that the $600K payment to Steelervest was a deductible business expense, not a non-deductible loan repayment. He further indicated that the payment could not have been a loan repayment because all debts were extinguished by the joint venture agreement. The IRS stated in its post-trial brief that the $600K payment to Steelervest must have been a debt repayment because it was not a participant in a joint venture with Las Olas and that it was essentially a substituted obligation for the cancelled promissory notes.

In testimony during the appeal, in testimony by Steelervest’s attorney, he indicated that the purpose of the AJV agreement was too cancel the notes issued to Long’s original company and transfer the indebtedness to profits from the project. Essentially, the $600K was a substituted obligation for the cancelled notes. The appeals court upheld the indicated that Long did not meet his burden of clearly establishing his entitlement to the deduction. The record demonstrates that the nature and character of the amended AJV agreement was to renegotiate Long’s repayment terms with respect to the Steelervest indebtedness. Accordingly, the $600K was a loan repayment and does not qualify as a deductible expense. Moreover, Long provides no statutory support for his contention that the “profit participation” constitutes a deductible expense.

$5.75M received for litigation

Long presented the $5.75M income payment as a capital gain on his tax return. He asserted that his income from the assignment agreement constituted the sale of an asset and, therefore, he should recognize a long-term capital gain. The IRS argued that the $5.75M received by Long from the assignment agreement constituted ordinary income, specifically because he received the money in lieu of future ordinary income payments, under the “substitution for ordinary income doctrine” (Commissioner v. P.G. Lake, Inc.).

The tax court rejected Long’s arguments. It concluded that the joint venture agreement did not create a joint venture between Steelervest and Las Olas and therefore, the entire $5.75M Long received for his position in the litigation constituted non-deductible, taxable income. Finally, it determined that Long intended to sell the land related to the lawsuit to a developer and concluded that the applicability of the capital gain statute depended on whether Long intended to sell the land to customers in the ordinary course of business. Since Long only intended to sell the land for the tower project, and not the individual condominium units themselves, the $5.75M for his position in the lawsuit nevertheless constituted ordinary income because he intended to sell the land to customers in the ordinary course of business.

The appeals court indicated that the tax court erred by misconstruing the property subject to capital gains analysis under Section 1221. The tax court analyzed the capital gains issue as if the land subject to the agreement was the property that Long disposed of in return for $5.75M. However, it is clear that Long never actually owned the land and, instead, sold a judgment giving the exclusive right to purchase the land. In other words, Long did not sell the land itself, but rather his right to purchase the land, which is a distinct contractual right that may be a capital asset. In determining whether a lump sum payment serves as a substitute for ordinary income, the appeals court looked to “the type and nature of the underlying right or property assigned or transferred”. A lump sum payment for a fixed amount of future earned income is taxed as ordinary income. It cannot be said that the profit Long received from selling the right to attempt to finish developing a large residential project that was far from complete was a substitute for what he could have received had he completed the project himself. Long didn’t have a future right to income that was already earned. By selling his position in the litigation, he effectively sold his right to finish the project and earn the income that Long hoped to earn when he started the project. Taxing the sale of right to create and thereby profit at the highest rate would discourage many transfers of property that are beneficial to economic development. Long’s profit was not simply the amount he would have received eventually, discounted to present value. Rather, his rights in the property represented the potential to earn income in the future based on the owner’s actions in using it, not entitlement to the income merely by owning the property. Selling a right to earn future undetermined income, as opposed to selling a right to earned income, is a critical feature of a capital asset. The fact that the income earned from developing the project would otherwise be considered ordinary income is immaterial. Therefore, the appeals court held that the $5.75M received in the sale of Long’s position is characterized as a capital gain.

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