Capital gains on contract sale
Sale of a service contract produced capital gain rather than ordinary income, the US Tax Court said in June 2017.
The key was the contract qualified as a “franchise” to provide services in a particular geographic area.
Three partnerships held contracts with Tehama County and the cities of Red Bluff and San Jose in California to collect garbage and recyclables and to dispose of the garbage. The partnerships won the contracts by bidding for them after the municipalities issued requests for proposals. The contracts had limited terms. They could be renewed by agreement of the parties. The partnerships invested in garbage trucks, trash bins and other equipment.
An outside consultant approached the partnerships in 2002 about selling the business. A sale was arranged later the same year to Waste Connections for $46 million.
The parties allocated the purchase price among the three partnerships and among three categories of assets: covenants not to compete, the trucks and other tangible assets, and goodwill and going concern value.
The partnerships reported the gains largely as capital gains. The IRS audited in 2009 and insisted that the sellers had to report everything as ordinary income. Individuals are taxed on their capital gains at reduced rates. There is no difference in tax rates on corporate capital gains, but any capital losses a corporation is carrying forward can only be used to offset capital gains.
By the time the case got to court, it had come down to one issue: whether sale of the service contracts produced capital gains.
The court said yes. It said the contracts are “franchises” within the meaning of section 1253 of the US tax code. A taxpayer is allowed to report any gain from the sale of a franchise as capital gain as long as it does not retain a continuing interest in the franchise after the sale. A contract qualifies as a “franchise” if it is “an agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area.”
The case is Greenteam Materials Recovery Facility PN v. Commissioner.
The IRS said in October 2019 that it does not agree with the decision and will continue to insist that companies report the purchase price in cases like this as ordinary income. It made the announcement in Action on Decision 2019-03.