Presentation:
Federal Income Taxation
Chapter 21 Character of Future Income
Streams
Professor Wells
November 18, 2015
1 Common Law: Substitute for Rent
Hort v. Commissioner
p.1163
Lump sum payment received by owner upon cancellation of lease
as a substitute for future rent.
“Substitute for Ordinary Income” proves too much, so what is
going on?
2 McAllister v. Commissioner
p.1166
Facts: Richard McAllister (Richard I) by will created a trust fund of
$100,000. The income was to go to his son John for life, then to
John’s widow for life, then to John’s brother, Richard II. When John
died, his estate needed cash, so his widow, the taxpayer in this case,
sold her life estate to Richard II for $55,000. She reported a capital
loss of $8,790.
Held: The taxpayer’s position is sustained. She sold a
property interest or right. This was not an assignment of
income. Consideration received characterized as capital
gain.
Congress fixes the basis issue with §1001(e) but leaves capital gain
treatment alone.
Cf., Blair case re assignment of income.
3 Oil Payments
Commissioner v. P.G. Lake
p.1171
Corporation transferred a 600x oil payment to officer to pay
loan. Treatment of assignment as a capital asset transfer.
Held taxable as ordinary income since a substitute for
ordinary income.
Response is Code §636 – treat the transaction as a loan.
4 Receipt of Payments for Future Income p.1181
Commissioner v. Carter
Mrs. Carter received 32 oil brokerage contracts in liquidation of
corporation in exchange for her stock. These contracts had no
ascertainable value in 1942. In 1943, Mrs. Carter was paid $34,992.20
on these contracts.
Issue: Is the 1943 payments ordinary income or capital gain to Mrs.
Carter?
Tax Court: Held this payment was capital gain.
Second Circuit. Affirmed. Generally, receipt of cash on business
contracts would be ordinary income. However, Mrs. Carter’s stock was a
capital asset, and this $34,992.20 was received as part of the overall sale
or exchange of her stock in the 1942 liquidation. Because the 1943
payment relates to that 1942 liquidation, the additional proceeds take
their character from that earlier transaction.
5 Bootstrap Sale to Charity
Commissioner v. Brown
p.1185
Clay Brown and family owned all the shares of Clay Brown & Co. (CB Co.).
1.  Clay Brown sold their shares to the California Institute for Cancer Research for $1,300,000, payable $5,000 cash
at the outset and the rest in deferred payments over not more than 10 years.
2.  Tax Exempt Liquidated CB Co.
3.  Tax Exempt Leased operating assets to Fortuna, owned by Clay Brown and lease set to equal 80 percent of its
operating profits (before depreciation).
4.  Fortuna deducted the lease payments and the Charity was nontaxable on its receipt.
5.  The Charity used the proceeds to pay Clay Brown the purchase price which was equal to 72% of operating
profits. Clay Brown claimed Long-Term Capital Gain Treatment on the gain from the contingent sales price.
Held: Clay Brown wins
5
Clay Brown
CB Co.
Corporate Taxes
After-Corporate Taxes
Individual Taxes
After-Tax Cash To Clay Brown
(72% of Profits)
1
Tax Exempt
Liquidate
Rent
2
Before
100,000
52%
(52,000)
48,000
70%
(33,600)
14,400
Rent
CB Co.
3
Lease Assets
Clay Brown
(80% of Pro
fits)
4
Fortuna
After
100,000
0 Corporate Taxes (Deductible As "Rent")
100,000
(10,000) Cal. Inst. Retention
90,000 Payment to Clay Brown
(22,500) Capital Gains Taxes (25%)
67,500 After-Tax Cash to Clay Brown
6 Lattera Synthesis “Family Resemblence Test”
Supp. pp. 99-106
Judge Ambro Posits this synthesis:
Step One: Look to Type of Carve-Out First. Horizontal carve-out leads to
ordinary income. Vertical carve-outs lead to step #2.
Step Two: Because a vertical carve-out could signal either capital gains or
ordinary income, we then look to the character of the underlying asset and apply
the “family resemblance test.”
A.  Assets gives a right to Earned Income create ordinary income when
sold (examples: landlord’s leasehold rights in rental, annuity rights, right
to interest income return, contractual payment rights). All of these
resemble a right to already earned income. If the sale is of property that
has a “family resemblance” to an asset that represents a right to earned
income, then ordinary income treatment.
B.  Assets that represent a right to Earn Income create capital gain
(stocks, land, tangible personal property). If the sale is of a vertical
interest in an asset that has a “family resemblance” to an asset that earns
income, then capital gain treatment.
7 Stern v. United States
p.1199
Facts: Stern sold rights in “Francis” the
talking mule to Universal Pictures for
$50,000 plus 5% of the net profits from
photoplays and 75% of the amounts
received from licensing. Stern reported
these amounts as capital gain.
Held: Amounts received prior to 1950
are capital gains because what was sold
was a capital asset under the 1939 Code.
But, when §1221(a)(3) was added in
1950, this prevented any amounts
received for a literary composition
created by taxpayer to no longer a capital
asset after 1950.
8 §1235
(General Comments)
p.1204
§1235, where it applies, provides capital gain treatment on
certain sales of a patent by an individual inventor.
Even where consideration is based on royalties.
All substantial rights in the patent to be transferred to enable
capital gains treatment.
§§1221 and 1231 may apply to transfers that are not subject to
§1235(a)
(But see 1221(b)(3) for musical copyrights).
9 Busse v. Commissioner
p.1204
Facts: taxpayer invented a method to stack cans on pallets and
assigned a 50% interest in the invention to his brother and
eventually became owned by his widow. The widow transferred the
patent to a corporation, and Section 1235 did not apply because the
transfer from the widow to the corporation was between related
parties (see §1235(c)).
Holding: The property was a capital asset and thus entitled to
capital gains treatment. No part of the capital gain is subject to
recast under §483 because the gain is described in Section 1235(a)
even though Section 1235 does not determine its treatment. See
§483(d)(4).
10 Theatrical Production Rights
Commissioner v. Ferrer
p.1207
1)
Surrender of the lease of the play is
not excluded from capital gains
treatment.
2)  Negative power to prevent disposition
of motion picture rights until after
play production – capital gain
proceeds.
3)  Right to receive portion of motion
picture proceeds – not capital.
Note: Section 1234A now states that the
extinguishment of an asset that is a capital
asset creates capital gain, thus in effect removing the sale or
exchange requirement for termination of capital asset rights in a
manner consistent with holding of Ferrer.
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