Capital Assets (Portfolio 561)

Tax Management Portfolio, Capital Assets, No. 561-3rd, discusses in detail the provisions of §1221. It summarizes the historical development of §1221, analyzes the definition of the term “property,” and describes certain traditional doctrines and other statutory provisions which affect the character of “property” and the tax treatment of a disposition of the property.

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Tax Management Portfolio, Capital Assets, No. 561-3rd, discusses in detail the provisions of §1221. It summarizes the historical development of §1221, analyzes the definition of the term “property,” and describes certain traditional doctrines and other statutory provisions which affect the character of “property” and the tax treatment of a disposition of the property.
For an item to be considered a capital asset under §1221, it must qualify as “property” and must not be specifically excluded from capital asset treatment. There are eight classes of exclusions: (1) stock in trade (inventory); (2) depreciable or real property used in a trade or business; (3) certain self created and other copyrights, literary, musical or artistic compositions, letters or memoranda or similar property; (4) accounts or notes receivable acquired in a trade or business; (5) certain federal publications received without consideration or at a discount; (6) certain commodities derivative financial instruments held by commodities dealers; (7) certain hedging transactions which are clearly defined as such before the close of the day on which the transaction was acquired, originated or entered into; and (8) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of the taxpayer's trade or business. Long-term capital gain rates will apply for assets held for more than 12 months. There is no tax rate benefit available to a corporation that itself is subject to tax.


Howard J. Rothman

Howard J. Rothman, B.A., City College of New York (1967); J.D., Brooklyn Law School (1971); LL.M. (Taxation) New York University School of Law (1972); Member, American Bar Association, Section of Taxation, Committee on Closely-Held Corporations, Subcommittee on Incorporations and Committee on Real Estate Tax Problems; and Committee on Partnerships; Member, New York Bar; Member, International Bar Association.

Pamela M. Capps

Pamela M. Capps, B.S.B.A., Washington University in St. Louis (1987); J.D., Columbia University (1992); Member, New York State Bar Association, Association of the Bar of the City of New York; Member, New York Bar.

Barry Herzog

Barry Herzog, B.A., Yeshiva University (1987); J.D., Columbia University (1991); Member, New York State Bar Association, Committee on Corporations; Member, American Bar Association, Section of Taxation; Member, New York Bar.

Table of Contents

Detailed Analysis

I. Introduction

II. Historical Development of Section 1221

III. Statutory Analysis

A. Introductory Comments - An Overview of Section 1221

B. The Sale or Exchange Requirement

1. General

a. Definition of ‘‘Sale or Exchange''

(1) Definition of a ‘‘Sale''

(2) Definition of an ‘‘Exchange''

b. Background

c. Statutory Sale or Exchange Treatment

d. Dispositions That Are Not Sales or Exchanges

e. Other Transactions

2. Treatment of Specific Types of Transactions as Sales or Exchanges

a. Dispositions of Debts: Retirement and Satisfaction of Bonds, Debts, and Other Obligations

(1) General

(2) Section 1271

(3) Case Law Not Involving Section 1271 or Its Predecessors

(4) Property Transfers by Debtor to Retire Debt

b. Cancellation, Lapse, Expiration or Other Termination of Rights or Obligations

(1) General

(2) Section 1241

(3) Section 1234A

(4) Case Law Not Involving Sections 1234A or 1241

(a) The Extinguishment Cases

(i) Ordinary Income

(ii) Capital Gain or Loss

(b) Substitute for Income - Comr. v. Pittston

(c) The Demise of the Extinguishment Cases

(d) Extinguishment Redux

(e) Post-Extinguishment Redux

c. Involuntary Dispositions

(1) General

(2) Section 1231

(3) Foreclosures and Conveyances by Deeds In Lieu of Foreclosure

(a) Outstanding Debt Exceeds Debtor's Basis in the Property

(i) Debtor is Solvent and Personally Liable on the Debt

(ii) Debtor is Solvent and Not Personally Liable on the Debt

(iii) Debtor is Insolvent and Personally Liable on the Debt

(iv) Debtor is Insolvent and Not Personally Liable on the Debt

(b) Debtor's Basis in the Property Exceeds Outstanding Debt

(c) Timing of Gain or Loss Recognition in a Foreclosure

d. Abandonment

(1) Abandonment of Property Where Taxpayer is Personally Liable on the Debt

(2) Abandonment of Property Where Taxpayer is Not Personally Liable on the Debt

e. Worthlessness of Securities

f. Default in Purchase

(1) Options

(a) Treatment of Grantor of Option

(b) Treatment of Holder of Option

(2) Treatment of Downpayments or Deposits Before September 5, 1997

(a) Treatment of Seller

(b) Treatment of Purchaser

(3) Treatment of Down Payments or Deposits After September 5, 1997

(a) General

(b) Treatment of Seller

(c) Treatment of Purchaser

(4) Default After Sale Completed

g. Shareholder's Transfer of Stock to Employees

h. Anticipatory Sales

i. Pension Plan Transfers

j. Corporate Distributions and Other Transactions

k. Transactions Through Conduits

l. Partition

C. The ‘‘Property'' Requirement

1. General

2. General Nonstatutory Exclusions to ‘‘Property'' Definition

a. Attributes of Property Approach

(1) General

(2) The Ferrer Case

(3) Rights to Acquire Interest in a Capital Asset

(4) Leasehold Interests

(5) Licenses

b. The Substitution of Ordinary Income Approach

(1) General

(2) Right to Collect Previously Accrued Income

(3) Right to Collect Income

(a) Substitute for Ordinary Income

(b) Insurance Agency Management Contract

(4) Right to Earn Income

(a) Personal Service Contracts

(b) Rights to Purchase Materials or Products

(c) Patent Rights

(d) Contract Rights

(5) Disguised Compensation

3. Specific Examples of Certain Rights as Property

a. Life Estates as Property

(1) General

(2) Disposition Aspects

b. Securities Futures Contracts as Property

c. Currency and Currency Contracts as Property

(1) Currency

(2) Currency Contracts

d. Oil, Gas, and Other Mineral Interests as Property

e. Interests in Privacy, Names, Trade Secrets, and Trade Names as Property

(1) Privacy

(2) Names

(3) Trade Secrets and Trade Names

f. Memberships in Organizations as Property

g. Miscellaneous Interests as Property

(1) Sham ‘‘Wine Contracts''

(2) ‘‘Whiskey Certificates''

(3) Rights Conditional Upon Condemnation of Property

(4) Development Rights in Agricultural Lands

(5) Water Contracts

(6) Bank Deposits

(7) Human Body Parts

(8) ‘‘Scalper'' Commodity Future Contracts

(9) Environmental Allowances and Credits

IV. Section 1221(a)(1) - Stock in Trade, Inventory, and Property Held Primarily for Sale

A. General

B. The ‘‘Primarily for Sale'' Requirement

1. Definition of ‘‘Primarily''

2. Change in Purpose

C. The ‘‘to Customers'' Requirement

D. Held for Sale in ‘‘Ordinary Course of the Taxpayer's Trade or Business'' Requirement

1. Number, Frequency and Continuity of Sales

2. Substantiality of Sales

3. Purpose for Acquisition and Reason for Which Property Is Held

4. Development Activities

5. Sales Activities

6. Duration of Ownership

7. Relationship of Property to Business

8. Maintaining Office and Necessary Requisite Licenses

9. Taxpayer's Statements

10. Replacement Property

E. Property Acquired by Inheritance or Gift

F. Single Sale and Single Customer Theories

1. Single Sale or ‘‘One-Bite'' Theory

2. Single Buyer Theory

G. Liquidation of Investment Theory

H. Related Party Activities

I. Real Property Subdivided for Sale - Section 1237 Safe Harbor

1. Statutory Requirements

2. Eligible Tract

3. The Five-Lot Rule

4. Other Real Estate Activities

5. Required Holding Period

6. Improvements

7. Gain and Selling Expenses-Computation

8. Condominium Conversion

9. Nonexclusivity of Section 1237 Safe Harbor

V. Section 1221(a)(2) - Depreciable Property and Real Property Used in a Trade or Business

A. In General

1. Historical Background

2. Relationship with Section 1231

3. Summary of Issues

B. Property of a Character Which is Subject to an Allowance for Depreciation

1. General

2. Property Which May Generally Be Depreciated

a. Tangible Property

(1) General

(2) Art Works

(3) Musical Instruments

(4) Containers

(5) Libraries

(6) Machinery and Equipment

(7) Nuclear Elements (Including Minerals)

(8) Transportation Property

(9) Signs

(10) Film, Musical, and Literary Properties

b. Intangible Property

(1) Section 197 Intangibles

(a) Goodwill and Going Concern Value

(b) Workforce in Place

(c) Information Base

(d) Know-How

(e) Customer-Based Intangibles

(f) Supplier-Based Intangibles

(g) Other Similar Items

(h) Licenses, Permits and Other Rights Granted by Governmental Units

(i) Covenants Not to Compete and Other Similar Arrangements

(j) Franchises, Trademarks, and Trade Names

(2) Exceptions to Definition of Section 197 Intangible

(a) In General

(b) Interests in a Corporation, Partnership Trust, or Estate

(c) Interests Under Certain Financial Contracts

(d) Interests in Land

(e) Certain Computer Software

(i) In General

(ii) Trade or Business or Substantial Portion Thereof

(f) Certain Interests in Films, Sound Recordings, Video Tapes, Books, or Other Similar Property

(g) Certain Rights to Receive Tangible Property or Services

(h) Certain Interests in Patents or Copyrights

(i) Copyrights

(j) Rights of Fixed Term or Duration

(k) Interests Under Leases of Tangible Property

(l) Interests Under Indebtedness

(m) Professional Sports Franchises

(n) Purchased Mortgage Servicing Rights

(o) Certain Transaction Costs

(p) Self-Created Intangibles

(q) Churned Intangibles

(3) Pre-1993 RRA

C. Real Property

D. Property ‘‘Used in a Taxpayer's Trade or Business''

1. The ‘‘Trade or Business'' Requirement

a. General Trade or Business Definitions

b. Rental Property as a Trade or Business

(1) General

(2) Ownership of a Single Parcel of Rented Real Property

(a) The Tax Court

(b) Seventh Circuit

(c) Second Circuit

(d) Sixth Circuit

(e) Court of Federal Claims

c. Property Acquired by Foreclosure

(1) General

(2) IRS, Tax Court, and Court of Federal Claims Position

(3) The Fifth Circuit Position

(4) The Second Circuit Position

d. Inherited Property

2. The Use Requirement

a. The Idle Property Problem

(1) General

(2) Property Always Idle

(3) Property Used in a Trade or Business Later Becomes Idle

b. Property Used By a Liquidating Corporation, Partnership, Limited Liability Company or Trust

c. Property Used In a Taxpayer's Former Trade or Business

3. The ‘‘Taxpayer's'' Property and the ‘‘Taxpayer's'' Trade or Business

VI. Section 1221(a)(3) - Copyrights, Literary, Musical, or Artistic Compositions, Letters or Memoranda, and Other Similar Property

A. General

B. Property Interests Under Section 1221(a)(3)

1. Idea or Concept

2. Title of Book, Radio Program, Etc.

3. Contract Rights

C. Copyrights, Literary, Musical, or Artistic Compositions, and Similar Property

1. General

2. Meaning of ‘‘Other Similar Property''

a. Scope of Phrase ‘‘Other Similar Property''

b. Pre-Section 1221(a)(3): Sale of Program or Screenplay by Actor, Director or Producer

c. Noncopyrightable Property

D. Letters or Memoranda or Similar Property

E. Property Created by Personal Efforts

1. General

2. The Regulations

3. The IRS Position

4. The Cases

5. Corporations as the Creators of Property

F. Taxpayers with Carryover Basis

1. General

2. Gifts

3. Inherited Property

4. Transfers to Corporations and Partnerships

VII. Section 1221(a)(4) - Accounts and Notes Receivable

A. General

B. Notes or Accounts Receivable Acquired for Services or Sale of Inventory or Stock in Trade

C. Notes or Accounts Receivable Not Acquired for Services or Inventory

D. Dealers in Notes or Accounts Receivable

VIII. Section 1221(a)(5) - United States Government Publications

A. General

B. Effective Date

IX. Section 1221(a)(6) - Commodity Derivatives Held by a Commodity Derivatives Dealer

X. Section 1221(a)(7) - Hedging Transactions

A. General

1. The 1999 Legislation

2. Hedging Regulations

3. Pre-Regulations Common Law

B. The Hedging Regulations

1. Overview

2. Hedging Transaction Defined

a. Ordinary Property, Ordinary Obligations and Borrowings

b. Risk Reduction and Risk Management

(1) In General

(2) The 2002 Regulations

(a) Risk Reduction Transactions

(i) Micro and Macro Hedges

(ii) Written Options

(iii) Fixed-to-Floating Price Hedges

(b) Risk Management Transactions

(i) Interest Rate Conversions

(ii) Transactions that Counteract Hedging Transactions

(iii) Recycling

(c) Transactions Not Entered Into Primarily to Reduce Risk

(3) The 1994 Regulations

3. Identification and Recordkeeping

a. The 2002 Regulations

b. The 1994 Regulations

4. Consolidated Groups

a. The 2002 Regulations

b. The 1994 Regulations

C. Pre-Regulations Common Law

1. The Pre-Corn Products Decisions

a. Securities Received for Goods and Services

b. Securities Acquired for Cash Incident to Business

c. Securities Acquired to Assure a Source of Supply

2. The Corn Products Decision

3. The Growth of the Corn Products Doctrine

a. The IRS's Early Position

b. Expanding the Corn Products Doctrine

(1) Source-of-Supply Cases

(2) Subsequent Change to Investment Motive

c. Source of Income Cases

(1) Captive Customer Cases

(2) Employment Protection Cases

(3) The FNMA Cases

d. Applying the Business/Investment Test to Wholly Owned Subsidiaries

e. Substantial Investment Test

(1) The Court of Federal Claims

(2) The Tax Court - W.W. Windle Co. v. Comr.

(3) Post-Windle Cases

(4) Post-Windle Cases Unaffected by Windle

(5) The IRS's Position

f. Disposition of a Limited Partner's Interest

g. Application of the Corn Products Doctrine to Holding Companies

4. The Arkansas Best Case - Supreme Court Rejects Broad Reading of Corn Products

5. Post-Arkansas Best Cases

XI. Section 1221(a)(8) - Supplies of a Type Regularly Used or Consumed by the Taxpayer in the Ordinary Course of a Trade or Business of the Taxpayer

XII. Short-Term Government Obligations Issued at a Discount

A. General

B. Former Section 1221(a)(5)

C. Obligations Included Within Former Section 1221(a)(5)

D. Analysis of the Elements of Gain

XIII. Judicial Recharacterization Doctrines

A. Judicial Recharacterization Based on Prior Transactions - The Arrowsmith Doctrine

1. General

2. Arrowsmith and Payments Under the Securities Act

3. Arrowsmith and Settlements and Other Payments

4. Integrated Events

B. The Open Transaction Doctrine

C. ‘‘Sales'' Used to Convert Ordinary Income Into Capital Gains - The Sham Transaction Doctrine

D. Corn Products and Its Progeny

XIV. Sale of a Business

A. Introduction

B. Section 1060: Allocation of Purchase Price in Applicable Asset Acquisitions

1. Historical Overview

2. Section 1060 Generally

3. Applicable Asset Acquisition

a. Trade or Business

(1) Section 355 Active Trade or Business

(2) Circumstances Under Which Goodwill or Going Concern Value Could Attach

(3) Transactions That May Fail the 1060 Trade or Business Requirement

(4) Multiple Trades or Businesses Transferred

b. Cost Basis

(1) In General

(2) Section 1031 Exchanges

4. Allocation of Consideration Among Assets

a. Consideration

(1) In General

(2) Transaction Costs

(3) Treatment of Covenants Not to Compete

(4) Treatment of Nuclear Decommissioning Funds

b. Fair Market Value

(1) In General

(2) IRS May Challenge; Taxpayers Bound

(3) Treatment of Liabilities

c. Asset Classes

(1) Current Regulations - Seven Classes

(2) Examples

d. Post-Closing Adjustments to Consideration

(1) Increases in Consideration

(2) Decreases in Consideration

(3) Contingent Income Assets

5. Certain Partnership Transactions

6. Information Reporting Requirements

a. In General

b. Certain Related-Party Transactions

7. Section 6050J Foreclosures

8. Comparison of 1060 to 338(h)(10)

C. Methods Other Than the Residual Method for Allocating Value to Intangibles

1. Formula Method or Capitalization Method

2. Second-Tier Allocation Method

3. Bargain Method

4. Allocations in Installment Sales

XV. Computation and Character of Capital Gain or Loss

A. General

B. Amount Realized

C. Basis

1. Property Acquired by Purchase

2. Property Acquired by Gift

3. Property Acquired by Inheritance

D. Holding Periods

1. General

2. Holding Periods Computations

3. Property Acquired From a Decedent

4. Tacked Holding Periods

5. Partnership Interests

6. Sale of Option Distinguished from Sale of Property

E. Carrybacks and Carryovers of Nondeductible Capital Losses

1. General

2. Noncorporate Taxpayers

a. General Rules

b. Use of Carryovers by Different Taxpayers Prohibited

3. Corporate Taxpayers

a. General Rules

b. Special Rules

(1) Carryback May Not Create Net Operating Losses

(2) Foreign Expropriation Capital Losses

(3) Specially Treated Corporations

(4) Limitations on Carryovers to Years Subsequent to Ownership Changes

(5) Limitation on Use of Capital Loss Carryovers and Carrybacks by Consolidated Groups

(6) Prohibition on Carryover or Carryback of Net Capital Losses To or From S Corporation Years

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Regs. Section 1.1221"1

Worksheet 2 H.R. Rep. No. 215 (Conf.), 97th Cong., 1st Sess. 258"260 (1981)

Worksheet 3 Legislative History Tax Reform Act of 1976 (P.L. 94-455 H.R. Rep. No. 1515, 94thCong., 2d Sess. 532-535 (1976)

Worksheet 4 H.R. Rep. No. 413, 91st Cong., 1st Sess. 148 (1969)

Worksheet 5 S. Rep. No. 1622, 83rd Cong., 2d Sess. 111, 431 (1954)

Worksheet 6 S. Rep. No. 703, 77th Cong., 1st Sess. 30"31 (1941)

Worksheet 7 Finding List of Related Tax Management Portfolios






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