Gains & Losses
The Eleventh Circuit held that a taxpayer's assignment of his rights in an ongoing lawsuit over a land sales contract was the sale of a right to purchase the land subject to the contract, not the sale of the land, and resulted in long-term capital gains to the taxpayer.
Background
From 1994 to 2006, Philip Long, as sole proprietor, owned and operated Las Olas Tower Co. Inc. (LOTC), which 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). LOTC never filed any corporate income tax returns and did not have a valid employer identification number. Instead, Long reported LOTC's income on the Schedule C, Profit or Loss From Business (Sole Proprietorship), of his individual tax return.
In 2002, Long, 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, with a set closing date of Dec. 31, 2004. LORH subsequently terminated the contract unilaterally and, in 2004, LOTC filed suit in Florida state court against LORH for specific performance of the contract and other damages. LOTC won at trial, and the court ordered LORH to sell the land to LOTC pursuant to the Riverside agreement. LORH appealed the judgment. In 2006, Long entered into an agreement with Louis Ferris Jr. (the assignment agreement), under which Long sold his position as plaintiff in the Riverside agreement lawsuit to Ferris for $5.75 million.
On his 2006 tax return filed in October 2007, Long reported the income from the assignment agreement as capital gains. In September 2010, the IRS issued a notice of deficiency for 2006 to Long, claiming among other things, that the income from the assignment agreement was ordinary income, not capital gains. Long challenged the IRS's determination in Tax Court.
In Tax Court, the IRS argued that Long received the $5.75 million in lieu of future ordinary income payments and, therefore, that money should be counted as ordinary income under the "substitution for ordinary income doctrine." The Tax Court, treating the assignment agreement as a sale of the land under the Riverside agreement, found that Long intended to sell the land to a developer and concluded that the applicability of the capital gains statute depended on whether Long intended to sell the land to customers in the ordinary course of his business. The Tax Court determined that, while Long intended to sell only 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 the Tax Court's decision to the Eleventh Circuit.
In the Eleventh Circuit, Long argued that the $5.75 million he received from the assignment agreement should be taxed as long-term capital gain rather than as ordinary income. Long contended 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. Therefore, the asset he had sold was the right to purchase land, not the land itself, and the sale was the sale of a capital asset and resulted in capital gains income.
In response, the IRS again argued that Long's proceeds from the assignment agreement were not capital gains from the sale of an asset, but rather a lump-sum substitution for the future ordinary income Long 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. Additionally, in light of this analysis, the IRS argued that the Tax Court's discussion of factors to determine Long's primary purpose for holding the property was irrelevant. Alternatively, the IRS argued that the assignment agreement was a sale of Long's judgment, which resulted in short-term capital gain because Long sold the judgment less than a year after it was entered by the Florida court.
The Eleventh Circuit's Decision
The Eleventh Circuit reversed the Tax Court and held that the income from the assignment agreement was capital gains rather than ordinary income. The Eleventh Circuit found that the Tax Court had erred by misconstruing what property Long had sold, and it rejected the IRS's arguments that the income was short-term capital gains or that the substitute-for-ordinary-income doctrine applied.
The Tax Court analyzed the capital gains issue as if the land subject to the Riverside agreement was the property that Long disposed of in return for $5.75 million. The Eleventh Circuit, however, found that the record from the Tax Court made clear 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. In other words, Long did not sell the land itself, but rather his right to purchase the land, which was a distinct contractual right that might be a capital asset.
The court explained that this distinction was material because the "property" subject to the capital gains analysis was really Long's exclusive right to purchase the property pursuant to the court judgment. Therefore, the correct inquiry was not whether Long intended to sell the land to customers in the ordinary course of his business but whether Long held the exclusive right to purchase the property primarily for sale to customers in the ordinary course of his trade or business. The court found that there was no evidence that Long entered into the Riverside agreement with the intent to assign his contractual rights in the ordinary course of business, nor was there evidence that, in the ordinary course of his business, Long obtained the court judgment for the purpose of assigning his position as plaintiff to a third party. Rather, the record indicated that Long always intended to fulfill the terms of the Riverside agreement and develop the Las Olas Tower project himself.
The court concluded that the IRS's short-term capital gains argument failed because the IRS was using the wrong date as the acquisition date for the asset that was subject to capital gains treatment. Because the court found that the asset was Long's exclusive right to purchase land, he obtained the asset in 2002 when he executed the Riverside agreement, which was well over one year before he sold the asset in 2006.
With respect to the substitute-for-ordinary-income doctrine, the Eleventh Circuit observed that whether the doctrine applied depended on the type and nature of the underlying right or property assigned or transferred. If a lump-sum payment is for a fixed amount of future earned income, it is taxed as ordinary income. In Long's case, the court concluded that the profit he received from selling the right to attempt to finish developing a large residential project that was far from complete was not a substitute for what he would have received had he completed the project himself. According to the court, Long's profit was not simply the amount he would have received eventually, discounted to present value. Rather, his rights in the LORH property represented the potential to earn income in the future and, under Eleventh Circuit precedent, 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. Thus, the court concluded, the fact that the income earned from developing the project would otherwise be considered ordinary income was immaterial.
Reflections
While the Eleventh Circuit correctly determined that the assignment agreement was not equivalent to a sale of the land subject to the Riverside agreement, it could be argued that it incorrectly determined that the assignment agreement was a sale of a right to purchase the land. At the time of the assignment, LORH's appeal of the trial court's decision in the litigation over the Riverside agreement was ongoing, and Ferris received Long's rights as plaintiff in that litigation. Given that the litigation was ongoing when the assignment agreement was executed, Long did not yet have a choate right to purchase the land. However, even if the court had found that Long had assigned his rights as a plaintiff, whatever those ultimately ended up being, presumably it would have still held that Long had long-term capital gains from the assignment.
Long, No. 14-10288 (11th Cir. 11/20/14)
