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By James M. Kehl, CPA
Mister, Burton & Palmisano, PC, Hunt Valley, MD
It is fairly common for a landlord or a tenant to receive payments in consideration for that party's allowing a lease to terminate before its required expiration date. Similarly, distributors may receive payments in exchange for cancellation of their distributorship agreements. These payments are income to the party who receives the payments. The question is whether these payments constitute ordinary income or whether these payments could constitute capital gain. This commentary will discuss these issues and the conditions necessary for characterization of payments for cancellation of leases or distributorship agreements as capital gain to the recipient of those payments.
A landlord may receive payments from a tenant in exchange for the landlord's cancellation of the landlord's rights to future rental payments under the lease. These amounts are characterized as ordinary income to the landlord. The reasoning for this treatment is that, in order for income from a transaction to constitute capital gain or loss, there must be a sale or exchange of a capital asset or of a §1231 asset held for more than one year that is used in a taxpayer's trade or business. The landlord is not considered as transferring an asset to the tenant, despite the fact that the landlord is relinquishing rights to future income. For this reason, payments received by a landlord for termination of the landlord's contractual rights to future rent payments are considered ordinary income to the landlord.1
A lessee or tenant may receive capital gain treatment for payments that the lessee receives in consideration for the lessee's or tenant's agreement to an early termination of a lease under certain circumstances. In order for a payment from a transaction to be characterized as part of a capital gain or loss, there are two conditions that must be fulfilled: (1) the payment must be from a sale or exchange of (2) a capital asset or of a §1231 asset. Section 1241 states that payments received by a lessee for cancellation of a lease are considered as amounts received in exchange for the lease, and thus provides that the lessee satisfies the exchange requirement. A “cancellation” is a termination of all of the tenant's or the lessee's contractual rights with respect to the leased property other than by expiration of the lease in accordance with its terms.2 Payment for partial cancellation of a lease may be characterized as a payment received in exchange for a lease if the cancellation is with respect to a severable economic unit, such as a portion of the property covered by the lease or a reduction in the lease's unexpired term.3 Payments received for lease modifications are not recognized as amounts received for cancellation.4 Thus payments received by a lessee for a lease's renewal, settlement, compromise or extension will not qualify for exchange treatment under §1241.
Payments that are refunds of advance rental payments are not considered as received in exchange for a lease and are thereby taxable as ordinary income to the lessee.5 It has also been held that an amount received by a controlling shareholder under an individual release and indemnity agreement from two controlled corporations were not, under the facts of this case, considered as cancellation payments under §1241.6
A lessee who fails to satisfy the provisions of §1241 may still obtain capital gain or loss and sale or exchange treatment if the lessee is considered, under other principles of tax law, as relinquishing a substantial property interest. For example, a lessee of property that relinquished its rights under a restrictive covenant that prohibited the landlord from renting any part of the leased building to a competing variety store was considered as relinquishing a substantial property right. As a result, this lessee was entitled to capital gain treatment on the transaction.7
After the exchange requirement is satisfied, the second requirement for capital gain treatment is that the lease must be either a capital asset or a §1231 asset held for more than one year in the hands of the lessee. Generally, a lease of property with respect to a taxpayer's trade or business will qualify for capital gain or loss treatment.8 For example, an apartment building owner paid a taxpayer's wife, children and attorney an amount of money in exchange for the taxpayer's leasehold interest in two apartments and also permitted the taxpayer to use an apartment rent-free for three years. The fair rental value of the apartment received and the amounts paid to the taxpayer's family and attorney were considered amounts received for the taxpayer's leasehold interests in the apartments and were considered payments for capital assets.9 Similarly, payments received by a lessee from a sublessee in exchange for the lessee's release of its rights under the lease to the landlord were considered as capital gains received from the sale of the lease.10
Section 1241 states that an amount received by a distributor of goods for cancellation of a distributorship agreement is consider as received in an exchange provided that the distributor has a substantial capital investment in the assets of the distributorship. An amount is considered as received in exchange for cancellation of a distributor's agreement if it is for a termination of all of the distributor's contractual rights with respect to the distributorship.11 A good faith payment received for partial cancellation of some of a distributor's rights under a distributorship agreement is characterized as an amount received for cancellation if the specific cancellation relates to a severable economic unit, such as the unexpired term of the distributorship agreement, distribution rights in one of several products or distribution rights in one of several areas.12 Section 1241 only applies to distributorship agreements that are for marketing or for marketing and servicing of goods.13 Section 1241 does not apply to distributorship agreements that are for selling intangible property or for rendering personal services.14 Examples of distributorship agreements for selling intangible property or for rendering services include agreements for establishing insurance agencies or security brokerages.15
An example of the application of these provisions concerns a distributor of food products. T is a distributor of various food products. T leases a warehouse including cold storage facilities and owns a number of trucks. T obtains the exclusive rights to market and distribute certain frozen food products of Company Y in state X. The distribution is accomplished by the use of warehouse and trucks that were acquired before T entered into the agreement, and entails no additional capital. Payments received by T from Y upon the cancellation of the agreement are treated as received in exchange for the distributorship agreement.16
In order to enjoy the benefits of the exchange provisions of §1241, a distributor must have a substantial capital investment in the distributorship. This substantial capital investment must be in physical assets, such as fixed assets and inventories.17 An investment in an office merely for the performance of clerical operations is not considered substantial.18 The substantial assets or capital that is necessary for carrying on the distributorship's operations must actually be acquired by the distributor and actually utilized in carrying on the distributorship prior to the cancellation of the distributorship agreement.19
For example, assume that in the above example, T entered into an exclusive distributorship agreement with Y under which T merely solicited orders through a staff of salesmen, with the goods shipped by Y directly to the purchasers. Payments received upon the cancellation of that distributorship agreement are not treated as received in exchange for the agreement.20
Section 1241 is a provision that can assist a lessee or a distributor in obtaining capital gain treatment on the cancellation of a lease or the cancellation of a distributorship agreement. Practitioners should be aware of this provision in the event that it may apply to situations the practitioners may encounter.
For more information, in the Tax Management Portfolios, see Holthouse, 593 T.M., Real Estate Leases, and Rothman, Brady, Capps, and Herzog, 561 T.M., Capital Assets, and in Tax Practice Series, see ¶1770, Miscellaneous Capital Gain v. Ordinary Income Issues, and ¶1630, Sale or Exchange Requirement.
1 See Holthouse, 593 T.M., Real Estate Leases.
2 Regs. §1.1241-1(b).
5 See Gray v. Comr.,642 F.2d 320 (9th Cir. 1981); Peerless Steel Equipment Co. v. Comr., 26 T.C.M. 880 (1967).
6 See S. Van Lede Est. v. Comr., 28 T.C.M. 1422 (1969).
7 See Ray v. Comr., 210 F.2d 390 (5th Cir. 1954).
8 See Rev. Rul. 72-85, 1972-1 C.B. 234; PLR 200045019.
9 Stotis v. Comr., 72 T.C.M. 704 (1996).
10 Metropolitan Building Co. v. Comr., 282 F.2d 592 (9th Cir. 1960).
11 Regs. §1.1241-1(b).
12 Regs. §1.1241-1(b).
13 Regs. §1.1241-1(c).
16 Regs. §1.1241-1(c), Ex. (1).
20 Regs. §1.1241-1(c), Ex. (2).
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