Cri-Leslie, LLC v. Comm'r

CRI-LESLIE, LLC, DONALD W. WALLACE, TAX MATTERS PARTNER, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

147 T.C. No. 8

Docket No. 1454-14.

UNITED STATES TAX COURT

September 7, 2016

P, the tax matters partner for a limited liability company treated as a TEFRA partnership for Federal income tax purposes, asserts that the partnership is entitled to capital gain treatment under I.R.C. sec. 1234A for its right to retain forfeited deposits of $9,700,000 from a canceled sale of real property used in its trade or business in the 2008 tax year. The real property was not a "capital asset" as defined in I.R.C. sec. 1221(a) but was I.R.C. sec. 1231 property.

Held: The partnership is not entitled to capital gain treatment on the forfeited deposit. I.R.C. sec. 1234A applies only to capital assets, not to I.R.C. sec. 1231 property. Leslie Joel Barnett, David L. Koche, Micah G. Fogarty, and Christopher R. Dingman, for petitioner.

Timothy A. Sloane, Andrew Michael Tiktin, and Lauren Epstein, for respondent.

OPINION

LARO, Judge: This case is a partnership-level proceeding subject to the unified audit and litigation procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, sec. 402(a), 96 Stat. at 648. Petitioner, Donald W. Wallace, the tax matters partner (TMP), asserts that respondent's notice of final partnership administrative adjustment (FPAA) issued to CRI-Leslie, LLC (CRI-Leslie), for the 2008 tax year improperly recharacterized an item of capital gain as ordinary income. Respondent determined an adjustment to CRI-Leslie's Federal income tax return by increasing its ordinary income by $9,700,000 and decreasing net long-term capital gain by the same amount.¹ Thiscase upon joint motion of the parties was submitted fully stipulated for decision without trial. See Rule 122.²

The issue before us, which is one of first impression, is whether CRI-Leslie is entitled to capital gain treatment under section 1234A for its right to retain forfeited deposits of $9,700,000 from a canceled sale of real property used in its trade or business in the 2008 tax year. We hold that it is not.

Background

I. Overview

Upon the parties' joint motion, the case is deemed fully stipulated under Rule 122. The stipulations of fact and the facts drawn from stipulated exhibits are incorporated herein. Petitioner is the TMP of CRI-Leslie. This case is appealable to the Court of Appeals for the Eleventh Circuit absent stipulation of the parties to the contrary.

II. CRI-Leslie

CRI-Leslie was a Florida limited liability company during the 2008 tax year. For Federal income tax purposes, it was a TEFRA partnership. Its principal placeof business was in Florida at the time the petition in this case was filed, and it has been on the accrual method of accounting at all relevant times.

During 2008 CRI-Causeway, LLC, a Florida limited liability company (CRI-Causeway), and Leslie Hawk, LLC, owned 100% of the capital, profits, and loss interests in CRI-Leslie. Capital Realty Investors, LLC, a Florida limited liability company (Capital Realty), owned 100% of CRI-Causeway and treated CRI-Causeway as a disregarded entity for Federal income tax purposes. Donald W. Wallace and Ben Wacksman each owned a 50% capital, profits, and loss interest in Capital Realty.

CRI-Leslie had filed a Form 1065, U.S. Return of Partnership Income, for the taxable year ended December 31, 2008. On November 20, 2013, respondent mailed the FPAA for the 2008 tax year to the partners of CRI-Leslie, including indirect partner Donald W. Wallace.³

III. The Radisson Bay Harbor Hotel

On February 25, 2005, CRI-Leslie acquired for $13.8 million the Radisson Bay Harbor Hotel in Tampa, Florida. The property consisted of both land andimprovements thereon. The improvements included the hotel, Crabby Bill's Restaurant, a swimming pool, a parking lot, and landscaping.

After purchasing the property CRI-Leslie hired a third party to manage the operations of the hotel and restaurant on the property.

On July 10, 2006, CRI-Leslie entered into an agreement of purchase and sale with RPS, LLC. Under this agreement, CRI-Leslie agreed to sell the property to RPS, LLC, for $39 million. The agreement was revised and amended several times over the next two years, including an increase in the property's purchase price to $39.2 million. RPS, LLC, did not close the purchase of the property from CRI-Leslie, and the agreement terminated in 2008 by its terms.

CRI-Leslie claimed deductions under section 162 on its 2008 partnership return for expenses related to the operation of the hotel. CRI-Leslie also claimed a deduction for depreciation under section 167 with respect to the hotel on its 2008 partnership return.

IV. Forfeited Deposits

CRI-Leslie received $9,700,000 of deposits from RPS, LLC, in connection with the agreement. These deposits would have been applied to the property's purchase price if the sale had closed. RPS, LLC, defaulted on the agreement in 2008 and forfeited the total sum of deposits equal to $9,700,000 paid to CRI-Leslie in that year.

CRI-Leslie reported the $9,700,000 of deposits as net long-term capital gain on Schedule K, line 9a, Partner's Distributive Share Items, of its 2008 partnership income tax return. The parties have stipulated that this amount is includible in CRI-Leslie's income for taxable year 2008. The parties have further stipulated that from the date that CRI-Leslie acquired the property in 2005 and through December 31, 2008, the property was real property used in CRI-Leslie's hotel and restaurant business within the meaning of section 1221(a)(2). The parties have also stipulated that the property constitutes "property used in a trade or business", as defined by section 1231(b)(1), of CRI-Leslie for the 2008 tax year.⁴ And the parties stipulate that had CRI-Leslie sold the property in 2008 pursuant to the agreement's terms, the gain from the sale would have resulted in net section 1231 gain reportable by CRI-Leslie on Schedule K of its 2008 income tax return.

Discussion

I. Overview

The Code generally provides for more favorable tax rates on "net capital gain" than it does on ordinary income. See sec. 1(h). Net capital gain is "the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for such year." Sec. 1222(11). Long-term capital gain, in turn, is "gain from the sale or exchange of a capital asset held for more than 1 year". Sec. 1222(3). Section 1221(a) defines capital assets generally. Under section 1221(a)(2) specifically, a capital asset is "property held by the taxpayer (whether or not connected with his trade or business), but does not include * * * property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business".

In a given tax year, if there is net gain from the sale or exchange of depreciable property--or real property--used in a trade or business and held for more than one year, see sec. 1231(b)(1), the Code provides that such gain "shall be treated as long-term capital gains", sec. 1231(a)(1). On the other hand, if there is a net loss from this type of property, that loss is treated as an ordinary loss. Sec. 1231(a)(2).

The Code also addresses the treatment of gain and loss from the sale or exchange of options. Thus, in the case of a purchaser of an option, section 1234(a)(1) provides:

Gain or loss attributable to the sale or exchange of, or loss attributable to failure to exercise, an option to buy or sell property shall be considered gain or loss from the sale or exchange of property which has the same character as the property to which the option relates has in the hands of the taxpayer (or would have in the hands of the taxpayer if acquired by him).

Section 1234B(a)(1) provides for similar treatment for gains or losses from securities futures contracts. For a grantor of an option, "gain or loss from any closing transaction with respect to, and gain on lapse of, an option in property shall be treated as a gain or loss from the sale or exchange of a capital asset held not more than 1 year." Sec. 1234(b)(1).

There is a separate Code section covering gains or losses from terminations of certain contractual rights:

SEC. 1234A. GAINS OR LOSSES FROM CERTAIN TERMINATIONS.

Gain or loss attributable to the cancellation, lapse, expiration, or other termination of--

(1) a right or obligation (other than a securities futures contract, as defined in section 1234B) with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer, or (2) a section 1256 contract (as defined in section 1256) not described in paragraph (1) which is a capital asset in the hands of the taxpayer,

shall be treated as gain or loss from the sale of a capital asset. The preceding sentence shall not apply to the retirement of any debt instrument (whether or not through a trust or other participation arrangement).

The Internal Revenue Service has not promulgated any final regulations under section 1234A. However, under proposed regulations, any gain or loss from termination payments under notional principal contracts and settlements of obligations under bullet swaps and forward contracts is treated as gain or loss from a termination of the notional principal contract, bullet swaps, or forward contract, respectively. Sec. 1.1234A-1, Proposed Income Tax Regs., 69 Fed. Reg. 8898 (Feb. 26, 2004).

There is no question that section 1234A extends to rights or obligations relating to property that is described in section 1221(a)--that is, to capital assets. However, as noted above, section 1221(a)(2) excludes depreciable property used in the taxpayer's trade or business as well as real property used in his trade or business.

The parties have stipulated that the property at issue is real property used in CRI-Leslie's hotel and restaurant business, meaning that it falls within section 1221...