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Eleventh Circuit: Contract Termination Payment Was Ordinary Income, Not Capital Gain

(Parker Tax Publishing March 2018)

The Eleventh Circuit, in a case of first impression, affirmed a Tax Court holding that a taxpayer who contracted to sell a hotel and restaurant that it used in its trade or business had ordinary income on the receipt of an advance deposit that it retained when the buyer defaulted on the contract. The court found that, under the plain language of Code Sec. 1234A, capital gain treatment applies only to termination payments where the underlying asset is a capital asset, and does not apply if the property is used in a trade or business. CRI-Leslie, LLC v. Comm'r, 2018 PTC 42 (11th Cir. 2018).

In 2005, CRI-Leslie, LLC bought a hotel and restaurant in Tampa, Florida for $13.8 million. CRI-Leslie ultimately hoped to sell the property for a profit, but it hired a third party to run the hotel and restaurant in the meantime. A year later, CRI-Leslie reached an agreement to sell the property for $39 million. Over the next two years, while CRI-Leslie continued to operate the business, the parties amended the contract several times and settled on a purchase price of $39.2 million, $9.7 million of which was paid immediately to CRI-Leslie as a nonrefundable deposit. The deposit was to be credited toward the purchase price at closing. However, the buyer defaulted on the agreement and forfeited the deposit.

On its 2008 tax return, CRI-Leslie reported the $9.7 million as long-term capital gain. The IRS determined that the amount should have been reported as ordinary income. CRI-Leslie petitioned the Tax Court for a readjustment, and the Tax Court found in the IRS's favor. CRI-Leslie appealed to the Court of Appeals for the Eleventh Circuit.

Under Code Sec. 1234A, the gain or loss from the termination of a contract to sell a capital asset is treated the same as if the sale were completed. A capital asset is defined in Code Sec. 1221(a)(2) to exclude property used in a trade or business. The parties stipulated that the hotel and restaurant property was property used in CRI-Leslie's trade or business and therefore Code Sec. 1231 property.

On appeal, CRI-Leslie argued that it made no sense to treat the same deposit that would have been capital gain if the deal had been completed as ordinary income solely because the contract fell through, especially given that it was not CRI-Leslie's fault that the deal was not completed. It also reasoned that such treatment penalized taxpayers who actively operated a business as opposed to being a passive investor. CRI-Leslie also contended that the legislative history of Code Sec. 1234A showed Congress's intent for the statute to have a broader application than just to capital assets. CRI-Leslie pointed out that Congress amended Code Sec. 1234A in 1997 to apply to real property out of concern for the tax treatment of deposits retained by commercial lessors. CRI-Leslie argued that leased real estate is clearly trade or business property under Code Sec. 1231. If Code Sec. 1234A applied to a payment resulting from the termination of a real property lease then, CRI-Leslie argued, it must also apply to a termination payment for the sale of the same type of property.

The Eleventh Circuit rejected CRI-Leslie's arguments and held that the termination payment was ordinary income under the plain language of Code Sec. 1234A. First, the court found that while the plain meaning of a statute can be ignored if it produces an absurd result, such was not the case here. According to the court, the absurdity rule applies only when a straightforward application of the text would compel a truly ridiculous outcome. The Eleventh Circuit determined that there was no such outcome here, particularly given that when the sale fell through, CRI-Leslie got to keep not only the $9.7 million but also the hotel and restaurant.

Next, the Eleventh Circuit recognized some merit to CRI-Leslie's argument as to Congressional intent but concluded that it was foreclosed by the plain language of the statute. The court reiterated that, by definition, Code Sec. 1231 property is not Code Sec. 1234A property. The definitions of property used in a trade or business and capital asset are mutually exclusive and, as the court pointed out, the plain language of Code Sec. 1234A applies only to the latter. The court reasoned that if Congress meant for Code Sec. 1234A to reach beyond capital assets and include Code Sec. 1231 property, then it was Congress's job to amend the Code.

For a discussion of the tax treatment of termination payments, see Parker Tax ¶116,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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