Code’s plain language prevails, despite anomalies

The Eleventh Circuit, affirming the Tax Court, held that the owner of a hotel and restaurant complex used in its trade or business was not entitled to capital gains treatment under Sec. 1234A for a deposit it retained after a would-be buyer terminated a contract to purchase the complex.

Background

In 2005, CRI-Leslie LLC paid $13.8 million to buy the Radisson Bay Harbor Hotel in Tampa, Fla., the hotel’s restaurant — Crabby Bill’s — and the prime waterfront property on which both stood. CRI-Leslie ultimately hoped to sell the Bay Harbor complex for a profit, but it hired a third party to run the hotel and restaurant until it was able to do so.

Just more than a year later, CRI-Leslie reached an agreement to sell the Bay Harbor complex to another company for $39 million. Over the course of the next two years — during which CRI-Leslie (through its manager) continued to operate the hotel and restaurant — the parties amended the contract several times, eventually settling on a total purchase price of $39.2 million. The buyer paid $9.7 million immediately to CRI-Leslie as a nonrefundable deposit that would be credited toward the purchase price at closing. Unfortunately, in 2008 the buyer defaulted on the agreement and forfeited the $9.7 million deposit.

On its 2008 tax return, CRI-Leslie reported the $9.7 million as long-term capital gain. The IRS disagreed with this position, and it issued a notice of final partnership administrative adjustment to CRI-Leslie for the 2008 tax year in which it determined that CRI-Leslie had improperly reported the amount of the forfeited deposits as net long-term capital gain rather than ordinary income.

In response, CRI-Leslie filed a petition with the Tax Court, challenging the IRS’s determination. The company asserted that the Code was meant to apply the same tax treatment for gains related to the disposition of “trade or business” property regardless of whether the property is successfully sold or (as here) the sale agreement is canceled. The IRS contended that the plain text of the governing Code provisions distinguishes between consummated and terminated sales of trade-or-business property, providing capital gains treatment only for the former. The parties jointly submitted the case to the Tax Court for decision without trial, and that court agreed with the IRS, holding that under the Code’s unambiguous language, CRI-Leslie could not treat the forfeited deposit as capital gain (CRI-Leslie, LLC, 147 T.C. 217 (2016)). CRI-Leslie appealed to the Eleventh Circuit.

The governing Code provisions

Under Sec. 1222(3), the gain from the sale or exchange of a capital asset held for more than one year is treated as long-term capital gain. Under Sec. 1221(a)(2), specifically, a capital asset is “property held by the taxpayer (whether or not connected with his trade or business), but does not include . . . property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business.” Under Sec. 1231, in a given tax year, if there is net gain from the sale or exchange of depreciable property — or real property — used in a trade or business and held for more than one year, the Code provides that such gain “shall be treated as long-term capital gains.”

A special rule covers gains or losses from terminations of certain contractual rights. Under Sec. 1234A, gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation (other than a Sec. 1234B securities futures contract) with respect to property that is (or on acquisition would be) a capital asset in the taxpayer’s hands is treated as gain or loss from the sale of a capital asset.

The Eleventh Circuit’s decision

The Eleventh Circuit affirmed the Tax Court’s holding that CRI-Leslie could not treat the forfeited deposit as capital gains. The court found that, contrary to the company’s contentions, this result was not absurd or contrary to Congress’s intent behind Sec. 1234A.

The court began by noting that CRI-Leslie and the IRS agreed that if the sale of the Bay Harbor complex had gone through as planned, the $9.7 million deposit — which under the contract’s terms would have been applied toward the purchase price — would have been taxed at the lower capital gains rate because the complex was property used in CRI-Leslie’s trade or business within the meaning of Sec. 1231. Thus, any income from the sale of the property would be Sec. 1231 gain treated as a long-term capital gain.

However, the court stated, because the deal fell through, the tax treatment of CRI-Leslie’s $9.7 million deposit was not governed by Sec. 1231, but rather by Sec. 1234A. Under Sec. 1234A, capital gain treatment applies only to property that is appropriately classified as a “capital asset in the hands of the taxpayer.” Thus, the court found that its determination turned on whether the Bay Harbor complex was a “capital asset” in CRI-Leslie’s hands during the 2008 tax year.

The court found that the express agreement between CRI-Leslie and the IRS answered this question. CRI-Leslie and the Service had stipulated “that from the date that CRI-Leslie acquired the property in 2005 and through December 31, 2008, the property was real property used in CRI-Leslie’s hotel and restaurant business within the meaning of section 1221(a)(2).” Accordingly, the court found, as had the Tax Court, that CRI-Leslie had conceded that the hotel was not a capital asset as defined in Sec. 1221. This meant that Sec. 1234A’s special rule, which treats property resulting from the termination of a contract for the sale of a “capital asset” as if it were derived from a consummated sale of that asset, and therefore subject to capital gains treatment, did not apply.

CRI-Leslie argued that this plain-text reading of the Code yielded a result that was “illogical, absurd, and directly contrary to the objective of § 1234A.” CRI-Leslie asserted that treating a deposit differently under a plain-language reading of Secs. 1221 and 1234A because a contract to sell property was terminated rather than completed made no sense and effectively penalized the company for operating a trade or business as opposed to being a passive investor in real property. CRI-Leslie argued that this disparate treatment reflected “intellectual inconsistency” and that the only rational way to read the Code was to treat a terminated contract the same way as a completed sale of the underlying property.

The Eleventh Circuit did not agree, stating that “[t]he supposed anomalies that CRI-Leslie posits — between completed and canceled transactions, and between active managers and passive investors — may seem a little (or even more than a little) odd, but oddity is not absurdity.” The court explained that the absurdity exception was very narrow and that it would apply only where a straightforward application of the statutory text would lead to a “truly ridiculous” result. The court concluded that this was not the case here, particularly given that CRI-Leslie got to keep the entire deposit and the Bay Harbor property.

Regarding whether the results were contrary to the purpose of Sec. 1234A, CRI-Leslie contended that the provision’s legislative history showed that its purpose was to ensure that taxpayers receive the same tax characterization of gain or loss whether the underlying property to a contract is sold or the contract is terminated. To fulfill this legislative purpose, the term “capital asset” in Sec. 1234A must be read to include Sec. 1231 property.

While the court acknowledged that this argument was not without foundation, the problem with it was that the language of the Code foreclosed it. According to the court, it was foreclosed because the definitions of “property used in the trade or business” in Sec. 1231 and “capital asset” in Sec. 1234A (via Sec. 1221) are mutually exclusive. While Sec. 1231’s definition, which applies to consummated sales of trade-or-business property, expressly prescribes capital gains treatment of the resulting income, Sec. 1221’s definition, which applies (via Sec. 1234A) to terminated sales of such property, expressly proscribes capital gains treatment. The court further found that where there is a contest “between clear statutory text and (even compelling) evidence of sub- or extra-textual ‘intent,’ the former must prevail.” Consequently, it concluded that CRI-Leslie’s intent argument failed.

Reflections

As the Eleventh Circuit notes in its opinion, some commentators have concluded that the legislative history does clearly establish that it was Congress’s intent that Sec. 1234A apply to Sec. 1231 property. While the court acknowledged that this might be the case and that Congress may have made an error in drafting the statute, if Congress did, Congress should correct it by amending the Code, which it has failed to do in the 21 years since Sec. 1234A was expanded to apply to all types of property.

CRI-Leslie, LLC, No. 16-17424 (11th Cir. 2/15/18)