A couple of years ago, this blog carried an article that briefly considered whether the gain realized by a taxpayer on the sale of a contract should be treated as ordinary income or capital gain for tax purposes.[i]

As it turned out, that piece has been one of the most popular articles that we have posted, and it has generated a number of inquiries, especially regarding the assignment of contracts that require the performance of a service by the assigning party (the “Contracts” and the “Assignor,” respectively) for the other party to the Contract.

Contract to Provide Services

It is obvious, if the Assignor does not sell the Contracts and, in accordance with their terms, continues to provide the agreed-upon services in exchange for the agreed-upon fee, that such fee will be reported on the Assignor’s tax return as ordinary income – compensation for services rendered.[ii]

It is equally clear, if the Assignor were to sell the Contracts in exchange for an amount equal to the present value of the fees payable under the Contracts, that the Assignor should treat the gain realized from the sale as ordinary income on their tax return.

In the case of such a payment – one made in lieu of future ordinary income payments – the taxpayer is merely converting future income into present income; they are accelerating the receipt of the ordinary income.[iii]

It may become more challenging to determine the nature of the gain arising from the assignment[iv] of the Contracts when the facts and circumstances of the assignment deviate from the straightforward scenario described above.

We begin our analysis by highlighting some of the factors I typically consider in determining the ordinary versus capital nature of the gain realized on the assignment of a Contract, which are derived in large part from those relied upon by the Courts.

Factors to Consider

Among the factors to consider are the following: the number of Contracts assigned, the number of service recipients to which such Contracts relate, the fraction of the Assignor’s overall business activity that the Contracts represent, the excess of the amount of consideration paid – including the assumption by the buyer-assignee of any liabilities of the Assignor beyond the performance of the services called for under the Contracts – over the present value of the compensation payable under the Contracts.[v]

The greater the magnitude of each of these factors, the greater the likelihood that at least a portion of the gain realized by the Assignor will be treated as capital gain.

In the end, it comes down to the nature of what is being transferred: (i) an opportunity to earn income by furnishing a specified service pursuant to a Contract, or (ii) part of a business or going concern that extends beyond the Contracts themselves? If the former, the resulting gain should constitute ordinary income; if the latter, at least part of the gain should be treated as capital gain.

This distinction may be supported by the facts and circumstances surrounding the transfer of the Contracts. Thus, additional support for capital gain treatment – specifically, for the transfer of a going concern or business – may be found if the consideration payable by the buyer in exchange for the Contracts is subject to adjustment downward (a claw-back) or upward (an earn-out), depending upon the revenues generated.[vi]

Similarly, a finding of capital gain would be bolstered if the assignment of the Contracts were attended by the transfer of other assets, including the Assignor’s files or other records pertaining to the service recipients or, more importantly, that portion of the Assignor’s workforce[vii] and independent contractors that services the Contracts. Given the technical nature of certain lines of business, the assignment of the Contracts to a buyer may be meaningless if it were not accompanied by the “assignment” of the skilled service-providers performing under those Contracts,[viii] along with the Assignor’s covenant not to solicit its former employees and not to compete with the buyer for the business of the service-recipient-parties under the Contracts.[ix]

The presence of some combination of the foregoing factors may indicate that the Assignor is transferring something more than the mere right to provide a service in exchange for ordinary compensation.

We will turn next to some of the relevant case law from which most of the foregoing factors have been distilled.

Before doing so, however, let’s review the underlying provisions of the Code that provide the impetus for our discussion; specifically, why does the capital gain versus ordinary income distinction matter?

Applicable Principles

A long-term capital gain is generated when there is a sale or exchange of a capital asset.[x]

A capital asset is defined as “property held by the taxpayer (whether or not connected with [their] trade or business),” subject to several statutory exceptions; for example, the taxpayer’s inventory, and real property or depreciable property used in the taxpayer’s trade or business.[xi]

As indicated above, the definition of a “capital asset” has never been read as broadly as the statutory language may seem to permit because such a reading would encompass items that Congress could not have intended to tax as capital gain, notwithstanding that they are not listed among the above-referenced exceptions to capital asset treatment; specifically, for our purposes, a service provider’s right to be paid for work to be performed in the future.

Thus, the Courts have limited the kinds of property that qualify as capital assets by explaining that not everything that can be called “property” in the ordinary sense, and that is outside the statutory exceptions to the definition of a “capital asset,” qualifies as a capital asset within the meaning of the Code,[xii] and they have developed arguments[xiii] that are intended to defeat attempts by individual taxpayers to “convert” ordinary income into capital gain; relevant to this post, the Courts have generally held that a mere right to receive ordinary income does not rise to the level of a capital asset.[xiv]

If an individual taxpayer were successful in such a conversion, income that would otherwise be subject to federal income tax at a maximum rate of 37-percent,[xv] would instead be taxed at a federal rate of 20-percent.[xvi]

In support of their position, taxpayers have argued that many capital assets are often valued on the basis of the present value of their future income stream. Thus, these taxpayers have asserted, it is possible to take the “substitute for ordinary income” doctrine too far, and to thereby define the term capital asset too narrowly.

The IRS has countered that taxpayers’ argument would result in treating as a capital asset any agreement that calls for services to be rendered in the future in exchange for a fee.

The Courts

Between these two extremes, the Courts have stated that they must make case-by-case judgements as to whether the conversion of income rights into a single payment reflects the sale of a capital asset that produces capital gain, or whether it produces ordinary income.

Unfortunately, the Courts have not always been consistent in their approach to the characterization of proceeds from the sale of contractual rights to earn income.

In one case, for example, the court found that two factors were crucial to its decision that a sale resulted in ordinary income, though it also conceded that these factors may not be dispositive in all cases: there was no underlying investment of capital by the taxpayer in exchange for the receipt of the “property right”, and the sale of the right did not reflect an accretion in value over such investment to any underlying asset held by the taxpayer.[xvii]

That being said, where the transaction at issue is the sale of a personal service contract – the sale of the right to perform personal services – the “substitute for ordinary income” rationale has been used to deny capital gain treatment for the seller, and to tax the proceeds from the sale as ordinary income. In other words, the sale of a contract to provide services to a client results in ordinary income.[xviii]

Some courts, however, have gone beyond this analysis. These courts have asked what the service rights under the contract represent. If they represent the right to earn future income in the form of commissions for services rendered, then the sum received for the transfer of rights is ordinary income.

One court stated that the holder of a right to earn income must do something to earn the income; the mere ownership of the right did not entitle the owner to income; thus, assets that represent the right to earn income should receive capital gain treatment.[xix]

Other courts look to the “components” of the contract to see if any of the rights thereunder are capital assets, as opposed to substitutes for future income.

According to these courts,[xx] the sale of all of the rights, title, obligations and benefits pertaining to a servicing contract, like the sale of any ongoing business, should be “comminuted into its fragments” and the purchase price for the contract should be allocated among the various assets sold. This allocation may, in turn, result in both ordinary income and capital gain, the latter including the seller’s relationship with its clientele; basically, the equivalent of goodwill, which is a capital asset.

However, the line between contractual rights representing capital assets and those representing the right to earn future income is far from clear, and there is the question of whether these two sets of rights are susceptible of separate valuation.

In other words, the taxpayer may be transferring several rights in one transaction, some of which may be characterized as interests in property that constitute capital assets and others which may not.

In one case,[xxi] the seller transferred its entire mortgage servicing business to the buyer. This included agreements, files, contracts, records and licenses that pertained to the business being sold. The seller also agreed not to compete with the buyer. A principal purpose for the buyer’s acquisition of the contracts and the related assets was to develop a relationship with one of the lending institutions being serviced.

The taxpayer argued that, in addition to the contracts, it had sold the going concern value associated with those contracts. The IRS argued that the only item sold was the taxpayer’s right to receive future service fees, so that the gain realized was ordinary income.

The Court recognized that some parts of the “bundle of rights” transferred were capital assets, but it also stated that it would be difficult to allocate the purchase price between the purchase of future income and the purchase of capital assets. However, because the Court was of the view that such an allocation was necessary,

In another decision,[xxii] the buyer-taxpayer became interested in acquiring from the seller the right to service certain mortgage loans. The buyer had no servicing department of its own, but it anticipated starting one by employing a large portion of the seller’s staff. The buyer examined a number of factors before agreeing to the transaction, including, for example, the number of mortgages and their probable remaining service lives. The buyer claimed that it only bought the servicing rights, and sought to amortize the purchase price (its cost) over the remaining service lives of the loans.

The IRS disagreed, asserting that not only did the buyer acquire the servicing rights for the existing mortgages, but also the seller’s rights to service future loans, its goodwill, and its value as a going concern.

The Court considered whether the seller had sold a capital asset in the nature of goodwill, or had sold the rights to future income in the form of servicing contracts. The Court noted that it is possible that the seller sold a combination of both. It discussed the Bisbee decision (see above), quoting from that part of the opinion explaining that some parts of the contractual rights transferred may be capital assets. It noted that the economic realities of the actual transaction were such that the buyer acquired, along with the rights to service existing loans, an opportunity to succeed the seller with respect to servicing future loans. This was a “preferred position,” the Court stated, and represented a business advantage. The fact that the contract made no mention of future loans, the Court continued, did not preclude a finding that part of the consideration was paid for this opportunity. In addition to acquiring the opportunity to service future loans, the buyer also acquired a closely related item: the value of the seller as a going concern. The seller’s personnel were expected, and did, continue to perform the same duties and services as they had for the seller. The fact that the sale agreement did not (and could not) state that the seller’s employees were bound over to the buyer did not detract from the probability that they would join the buyer’s operation – this too formed a part of the going-concern value that was purchased.

Where Does That Leave Us?

Somewhere along the continuum between the sale of a contract to perform services in exchange for a fee, on the one hand, and the sale of an entire business of which the contracts are but a portion of the assets acquired, on the other, lies an area in which a thorough examination of the facts and circumstances will be required in order to determine whether any part of the gain realized on the sale of such contracts may be treated as capital gain.

For example, if a taxpayer were to sell an entire division or line of business, would the contracts be lumped together with the going concern or goodwill that is associated with the assets sold, and taxed accordingly? Or would some portion of the consideration be allocated to the contracts and taxed accordingly?[xxiii]

As the sale swings the other way – toward an ever thinner slice of a business being transferred – it may be more difficult for the seller to substantiate the existence of, and to support an allocation of value to, an intangible asset the sale of which would generate capital gain. In that case, the seller may want to consider an agreement as to such an allocation with the buyer. However, the closer one gets to the “sale of a contract to perform services” side of the continuum, the less likely it is that such an agreement would be respected by the IRS.

As always, the taxpayer needs to be aware of the tax consequences of a sale prior to agreeing to the sale, and they need to know the factors that will influence the outcome of the transaction for tax purposes. Armed with this information, the economics of a transaction may be negotiated, or the deal terms may be structured, so as to minimize any adverse effects.


[i] https://www.taxlawforchb.com/2017/07/sale-of-a-contract-capital-gain-or-ordinary-income/

[ii] IRC Sec. 61(a)(1).

[iii] Hort v. Commissioner, 313 U.S. 28 (1941).

[iv] Assignment = Sale, for our purposes.

[v] A “premium,” one might say.

[vi] These mechanisms are typically used to shift economic risk to a seller in the context of a purchase and sale of a business.

[vii] Of course, one cannot “transfer” individuals, but the buyer will typically agree to offer them employment, and the Assignor will typically agree to use commercially reasonable efforts to facilitate the process.

[viii] Query the effect on the ordinary v. capital determination if the assignment agreement refers to IRS Rev. Proc. 2004-53 for the allocation of wage reporting responsibilities between the parties. This revenue procedure applies when a successor employer acquires substantially all the property (1) used in a trade or business of a predecessor employer, or (2) used in a separate unit of a trade or business of a predecessor, and, in connection with or immediately after the acquisition (but during the same calendar year), the successor employs individuals who immediately prior to the acquisition were employed in the trade or business of the predecessor.

[ix] Think along the lines of a “vertical slice” of the business.

In asset purchase transactions, such covenants are utilized to ensure that the seller will not impair the goodwill that the buyer has just purchased.

[x] IRC Sec. 1222. A capital gain may also be generated by the sale of property used in a trade or business (so-called “Section 1231 property”). Generally speaking, this includes real property used in a trade or business, as well as depreciable property used in a trade or business. IRC Sec. 1231(b).

[xi] IRC Sec. 1221.

[xii] Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130 (1960).

[xiii] For example, the “substitute for ordinary income” doctrine.

[xiv] Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958).

[xv] IRC Sec. 1. The maximum rate was 39.6-percent prior to the Tax Cuts and Jobs Act (“TCJA”; P.L. 115-97).

[xvi] IRC Sec. 1(h). In contrast, a C corporation is taxed at a flat federal rate of 21-percent (a maximum of 35-percent prior to the TCJA) regardless of the ordinary or capital nature of the income or gain.

[xvii] U.S. v. Maginnis, 356 F.3d 1179 (9th Cir. 2004).

[xviii] IRS FAA 20131901F.

[xix] Lattera v. Commissioner, 437 F.3d 399 (3d Cir. 2006).

[xx] See, e.g., Bisbee-Baldwin Corp. v. Tomlinson, 320 F.2d 929 (5th Cir. 1963).

[xxi] Realty Loan Corp. v. Commissioner, 54 T.C. 1083 (1970); aff’d 478 F.2d 1049 (9th Cir. 1973).

[xxii] First Pennsylvania Banking and Trust Company v. Commissioner, 56 T.C. 677 (1971).

A subsequent case agreed with the legal principle described above, but disagreed with its application to the facts before it. The service-provider/taxpayer received an amount from the service recipient in cancelation of their contract. The taxpayer argued that the transfer of its contract rights to perform personal services also included an element of goodwill (a capital asset). The court disagreed for a number of reasons, including the fact that the goodwill belonged to the service recipient’s products, there was no covenant by the taxpayer not to compete, the taxpayer did not transfer any records, and the employees (most of whom joined the buyer-organization) had no employment contracts and were free to leave the taxpayer at any time. Thus, the court found that nothing in the “bundle of rights” transferred by the taxpayer qualified as a capital asset, and it concluded that the payments received were simply a substitute for the income taxpayer would have received for performing services under the contract. Flower v. Commissioner, 61 T.C. 140 (1973).

[xxiii] Perhaps as a component of the seller’s so-called “customer-based intangibles” See IRC Sec. 197(d). PLR 201249013.