What Does It Mean?

The Tax Cuts and Jobs Act[1] has now been in effect for fifty days. During this relatively brief period, many tax professionals have pored over the statutory language, as well as the Joint Explanatory Statement issued by Congress, and, in the process, have found provisions that are in need of clarification. “That doesn’t make sense” or “that could not have been intended” are among the phrases that often accompany discussions of these provisions.[2]

2018 Tax Cuts and Jobs Act

These observations are usually followed by calls for legislative “technical corrections,” or for regulatory and other guidance from the IRS. It is as yet uncertain when such legislation or guidance will be forthcoming.[3]

A recent Court of Appeals decision, however, should serve as a reminder that it could be dangerous to ignore the text of a statutory provision that yields a result that one may believe was “clearly” not intended by Congress.

Termination of Contract Rights

Taxpayer purchased commercial real property (“Property”). Although Taxpayer ultimately hoped to sell Property for a profit, it hired a third party to operate Property in the meantime.

About one year later, Taxpayer reached an agreement to sell Property to another company at a significant profit. Over the next two years – during which Taxpayer continued to operate Property – the parties amended the contract several times, eventually finalizing the purchase price, and including a 25% nonrefundable Deposit that was paid immediately to Taxpayer, and that would thereafter be credited toward the purchase price at closing.[4] Unfortunately, the buyer defaulted on the agreement and forfeited the Deposit.

On its tax return for the year of the default, Taxpayer reported the Deposit as long-term capital gain. The IRS, however, determined that Taxpayer should have reported the amount of the forfeited Deposit as ordinary income.

Taxpayer petitioned the U.S. Tax Court, asserting that the Code was meant to prescribe the same tax treatment for gains related to the disposition of “trade-or-business” property regardless of whether the property was successfully sold or the sale agreement was canceled.

The IRS responded that the plain text of the governing Code provision distinguished between consummated and terminated sales of trade-or-business property, providing capital-gain treatment only for the former.

The Tax Court agreed with the IRS, holding that under the Code’s unambiguous language Taxpayer couldn’t treat the forfeited Deposit as capital gain.

Taxpayer appealed to the Eleventh Circuit.

Thus Spoke the Court[5]

Both Taxpayer and the IRS agreed that if the sale of Property had gone through as planned, the Deposit – which, under the contract, would have been applied toward the purchase price – would have been taxed at the lower capital-gains rate. The Code provides that “any recognized gain on the sale or exchange of property used in the trade or business” shall “be treated as long-term capital gain.”[6] The Code goes on to specify that, for purposes of this provision, the “term ‘property used in the trade or business’ means property used in the [taxpayer’s] trade or business, of a character which is subject to the allowance for depreciation …, held for more than 1 year, and real property used in the trade or business, held for more than 1 year …”

The parties stipulated that Property was properly classified as real property used in Taxpayer’s trade or business. Accordingly, it was undisputed that if Taxpayer had sold Property, the resulting income, including the Deposit, would have been taxed as long-term capital gain.

But the deal fell through, and Taxpayer did not sell Property. Accordingly, the tax treatment of the Deposit was governed by a different section of the Code[7] which provides, in relevant part, as follows:

Gain or loss attributable to the cancellation, lapse, expiration, or other termination of … a right or obligation … with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer … shall be treated as gain or loss from the sale of a capital asset.

Thus, any gain or loss that results from the termination of an agreement to buy or sell property that is properly classified as a “capital asset” will, notwithstanding the termination, be treated as a gain or loss from a consummated sale. This rule ensures capital-gain treatment of income resulting from canceled property sales by relaxing the “sale or exchange” element of the Code’s general definition of “long-term capital gain” – i.e., “gain from the sale or exchange of a capital asset held for more than 1 year ….”[8]

According to the Court, this rule applies only to property that is classified as a “capital asset.” The Court’s analysis, therefore, turned on whether Property was a capital asset in Taxpayer’s hands during the relevant tax year.

“As a matter of plain textual analysis,” the Court began, “the answer to the question whether [Property] was a ‘capital asset’ couldn’t be clearer.” The Code defines the term “capital asset” in a way that “expressly excluded” Property from status as a capital asset; specifically, the Code states that “the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include, [among other things,] real property used in his trade or business.”[9]

This definition of “capital asset, the Court noted, reflects almost precisely the definition of the term “property used in the trade or business,” examined above.[10] “There is, however, a decisive difference,” the Court continued, “which cuts to the very heart of this case: Whereas Section 1231’s definition, which applies to consummated sales of trade or business property, expressly prescribes capital-gains treatment of the resulting income, Section 1221’s definition, which applies to terminated sales of such property, expressly proscribes capital-gains treatment.”

Because Taxpayer’s sale transaction fell through, the controlling question, the Court stated, was whether Property was real property used in Taxpayer’s trade or business.

Taxpayer and the IRS stipulated that, from the date that Taxpayer acquired Property through the year at issue, Property was used by Taxpayer in a trade or business. Accordingly, Taxpayer “conceded that [Property] . . . was not a capital asset.”

“That concession,” the Court observed, “was fatal,” because it leads to the conclusion that the rule which treats the income realized on the termination of a sale contract as capital gain did not apply to the Deposit.

Taxpayer to Court: “That’s Not Fair”

In response, Taxpayer asserted that the Court’s plain-text reading of the Code impermissibly yielded a result that was “absurd.”

First, Taxpayer noted that while all “agree that, had the sale of [Property] been completed, the [Deposit] would have been … applied toward the purchase price and, thus, treated as capital gain,”[11] it made no sense that the same Deposit “must be treated as ordinary income because the parties terminated the [c]ontract rather than completing it,”[12] especially given that it was not Taxpayer’s fault that the sale did not occur.

Second, Taxpayer complained that the exclusion of trade-or-business property from capital-gain treatment on the cancellation of a contract for the sale of such property “effectively penalize[d]” taxpayers “for operating a trade or business as opposed to being a passive investor in real property,” in which case (as with a consummated transaction) any resulting income would receive capital-gain treatment.

For both reasons, Taxpayer insisted that the only rational way to read the Code was “to give the termination of a contract the same tax treatment afforded a sale or exchange of the property underlying the contract in order to eliminate differing tax treatment of economically equivalent transactions.”

The Court disagreed. The supposed anomalies that Taxpayer posited – between completed and canceled transactions, and between active managers and passive investors – may seem a little odd, the Court stated, but they did not yield such an “absurd” result that the straightforward application of the statutory text should not be respected, particularly given that, when the sale fell through, Taxpayer got to keep not only the Deposit (albeit at an ordinary-income tax rate) but also Property.

Taxpayer also insisted that a plain-text reading of the Code’s interlocking provisions actually “ignore[d] the clear purpose behind the enactment” of the provision[13] that treated the cancellation of a sale contract as the economic equivalent of a sale, which Taxpayer said “was to ensure that taxpayers receive the same tax characterization of gain or loss whether the underlying property is sold or the contract to which the property is subject is terminated.”

The problem with Taxpayer’s argument, the Court pointed out, is that the Code’s plain language forecloses it. If an asset – like Property – is “real property used in a trade or business,” then by definition it is not a “capital asset” within the meaning of the “cancellation-of-contract” provision.  The definitions of “property used the trade or business” and “capital asset” are mutually exclusive; while one provision expressly prescribes capital-gains treatment of such income, the other expressly forbids capital gains treatment of the same property.

The Court stated that in a contest between clear statutory text and evidence of sub- or extra-textual “intent,” the former must prevail. As a formal matter, it is of course only the statutory text, the Court continued, that is “law” in the constitutional sense; and as a practical matter, “conscientious adherence to the statutory text best ensures that citizens have fair notice of the rules that govern their conduct, incentivizes Congress to write clear laws, and keeps courts within their proper lane.”[14]

Accordingly, Taxpayer was not entitled to treat the Deposit as capital gain.

Harsh Result?

I don’t think so, especially given that Taxpayer got to keep the Deposit and Property. Moreover, the Court’s reading was wholly consistent with the plain language of the Code.

The lesson, of course, as we await clarification, correction, and guidance from Congress and the IRS regarding many provisions of the Tax Cuts and Jobs Act, is to proceed with caution, to avoid assumptions that are more hopeful than grounded on objective fact, to voice our opinions and concerns as tax professionals, and to keep abreast of developments in Washington.

[1] Pub. L. 115-97.

[2] See, for example, the apparent denial of a plaintiff’s deduction for legal fees incurred in pursuing a sexual harassment claim, the settlement of which includes a non-disclosure provision. “What we do in haste, . . .”

[3] The IRS announced recently that proposed regulations would be issued by the end of 2018, and final regulations by mid-2019. The Ways and Means Committee are supposedly gathering, and filtering through, the feedback given by tax professionals, but there has been no indication of when any substantive and/or technical changes will be proposed, let alone made.

[4] Under an “open transaction” theory, the recognition and treatment of such a deposit await the consummation or failure of the sale.

[5] No, I’m not getting metaphysical on you.

[6] IRC Sec. 1231.

[7] IRC Sec. 1234A.

[8] Sale of a Contract: Capital Gain or Ordinary Income?

[9] IRC Sec. 1221(a)(2).

[10] See FN 6, FN 9, and accompanying texts.

[11] Under IRC Sec. 1231. See FN 6.

[12] Under a plain-text reading of IRC Sections 1221 and 1234A.

[13] IRC Sec. 1234A.

[14] The Court observed, that even if Congress really did mean for Section 1234A to reach beyond “capital assets” as defined in Section 1221 to include Section-1231 property, “it’s not our place or prerogative to bandage the resulting wound. If Congress thinks that we’ve misapprehended its true intent – or, more accurately, that the language that it enacted in I.R.C. §§ 1221 and 1234A inaccurately reflects its true intent – then it can and should say so by amending the Code.”