It’s that time of year again – spring is over, summer has arrived, and every true red-blooded American (or maybe Alabamian) is obsessing over the world’s greatest sport – yes, I’m talking about the sport that truly matters: college football. While everyone has their own tradition or Saturday routine that makes college football special to them, a personal favorite of mine is watching “Game Day” every Saturday morning just to see what trickery Lee Corso will employ in announcing his pick to win the marquee game of the week. Right on cue, the Tax Court appears to be caught up in this same football fever as evidenced in a decision handed down just a few days ago.
In the recent Victor Fargo decision (T.C. Memo 2015-96), the stage was set for a perfectly routine holding that property sold was held as an investment, thus triggering capital gain to the taxpayer. In Victor Fargo, the taxpayer originally acquired a parcel of property for development purposes but, due to difficulties it faced in the development process, the taxpayer ceased development of the property and instead continued to rent the property out while waiting for the market to turn around so that the property could be profitably sold. To determine the character of the taxpayer’s gain from its subsequent sale of the property, the Court called a typical play: it applied an ordinary nine-factor test derived from Maddux Constr. Co. (54 T.C. 1278 (1970)) to determine if there was sufficient evidence of “changed purpose.” In executing this play, the Victor Fargo Court found a majority of the Maddux factors favored the taxpayer’s position that its purpose for holding this property had shifted to investment with the court specifically noting that the taxpayer had made virtually no substantial physical improvement to the property and that it had been continuously rented out.
So it seemed that if Judge Goeke was channeling Coach Lee Corso’s “Game Day” persona, he was about to put on his Bama Elephant Headgear, and find for the Taxpayer on the dealer status issue. ROLL TIDE! Instead, Judge Goeke caught many of us off-guard with his version of Corso’s trademark “Not so fast, my friend!”, holding that the taxpayer did not have an investment purpose for holding the property. Figuratively speaking, Judge Goeke put on his IRS (maybe it was Auburn, LSU or Tennessee, you pick) headgear and gave us all a surprise.
In deciding that the taxpayer in Victor Fargo was holding the property for sale to customers in the ordinary course of the taxpayer’s development business rather than for investment purposes, the Court emphasized the taxpayer’s intent at the time of the sale was the “crucial factor” for determining the character of this gain. By elevating the taxpayer’s subjective intent at the moment of the sale, the Court appears to take an even more nuanced approach by focusing on the precise type of consideration the taxpayer received. Specifically, the Court seems to give substantial weight to the fact that the taxpayer would receive some of the proceeds from the purchaser’s subsequent development of the property. By deeming this earn-out to be evidence of the taxpayer’s “development intent” at the time of sale, the Court concluded that 100% of the taxpayer’s gain must be characterized as ordinary notwithstanding the amount of evidence supporting the taxpayer’s position that the property was being held for investment purposes prior to the sale.
The moral of Victor Fargo decision is that regardless of why property is acquired or even how it is held, the particulars of the sale and the type of consideration received may trigger ordinary gain. Furthermore, this holding appears to necessitate an additional layer of inquiry in situations where the seller receives an earn-out like the one received by the taxpayer in the Victor Fargo case.
While the prudent approach to triggering unwanted ordinary income in these “changed purpose” situations undoubtedly still begins by applying a multi-factor inquiry (such as the nine-factor Maddux test), keeping in mind the Victor Fargo court’s emphasis on the seller’s intent and the type of consideration received may prove to be the tax attorney’s “Heisman moment” if it prevents even one client from becoming the next taxpayer to be caught off-guard by Coach Corso’s old hat trick.