The maximum effective marginal tax rate for individuals can now reach 41.4 percent (after limitations on itemized deductions and phase-out personal exemptions). By contrast, the long-term capital gains tax rate for noncorporate taxpayers is 20 percent (25 percent on unrecaptured § 1250 gain). For corporate taxpayers, ordinary income and long-term capital gains are taxed at 35 percent. From a rate perspective, it is therefore desirable, where possible, to structure individual business transactions so that capital asset status will be accorded.
Long-term capital gains are gains derived from the sale or exchange of a capital asset held for more than one year. The sale of property is a transfer in exchange for cash or a promise to pay. An exchange is a transfer of property for other property. The holding period of a capital asset must exceed one year in order to qualify as “long-term” capital gain. The foregoing two requirements may be difficult to achieve, but they are not difficult to understand. Defining the term “capital asset” has, by contrast, perplexed Courts.
Sec. 1221(1) defines the term “capital asset” as property (whether or not connected with a trade or business) other than “stock in trade . . . or other [inventory] property . . . or other property held by the taxpayer primarily for sale to customers in the ordinary course of trade or business,” commonly referred to as “dealer property”. [Sec. 1231 provides that to the extent Sec. 1231 gains exceed Sec. 1231 losses for any taxable year, such gains are treated as long-term capital gains. Sec. 1231 property consists of property used in a trade or business that is real property or depreciable property held more than one year.]
In achieving capital asset status, it is therefore important that property be characterized either as a capital asset or Section 1231 property, and not as “dealer property”. This is often a difficult inquiry.
The Corn Products doctrine, (SCt 1955), stood for the proposition that sales of futures contracts related to the purchase of raw materials resulted in ordinary income because the transactions represented an integral part of part of the business. This case illustrates that even assets which would literally fit the Sec. 1221 definition may be excluded from capital asset status.
Whether real estate, for example, qualifies as a capital asset depends upon the particular factual circumstances. To be excluded from capital asset status, Sec. 1221(1) provides that the property must be held “primarily for sale to customers in the ordinary course of a trade or business”. However, the taxpayer may hold real estate for both rental and sale purposes. The Supreme Court has held that exclusion from capital asset status will result only if the sale intent is predominant over the rental intent. Malat (1966).
The phrase “to customers in the ordinary course of a trade or business” has also been imparted with judicial gloss. The Supreme Court has held that Sec. 1221(1) is intended to distinguish between everyday profits and losses (ordinary income) and appreciation in value over a substantial period of time (capital asset). While this is a factual inquiry, Courts have held that frequent sales, substantive improvements, and active advertising efforts tend to indicate the existence of “dealer property” rather than investment (i.e., capital asset) property. Biedenharn Realty Co., 5th Cir. 1976.
Courts tend to allow capital gain treatment for real property acquired by gift or inheritance — even if the taxpayer engages in substantial improvement — provided the taxpayer liquidates the holdings in an “orderly and businesslike manner”. Yunker v. CIR, 6th Cir., 1958.
Partial conversation to capital gain may at times be all that is possible. For example, the sale after development of appreciated real estate will result in ordinary income. To convert pre-development appreciation to capital gain, the taxpayer could sell the undeveloped property to a controlled corporation on an installment basis, with the corporation taking a cost basis. Courts have tended to respect these transactions where there is a demonstrated likelihood of early repayment, and the corporation is not thinly capitalized.
Given the enormous rate differential between long-term capital gains and ordinary income, it may significantly benefit taxpayers to structure transactions in advance in order to maximize the likelihood of successfully claiming capital asset status.