Philip Long v. Commissioner of IRS
2014 U.S. App. LEXIS 21876, 114 A.F.T.R.2d (RIA) 6657, 772 F.3d 670 (2014)
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Rule of Law:
The sale of a right to create future, undetermined income through entrepreneurial activity, as opposed to the sale of an already earned or fixed future income stream, qualifies as a long-term capital gain, not ordinary income, because it does not fall under the 'substitute for ordinary income doctrine' exception to capital asset treatment.
Facts:
- From 1994 to 2006, Philip Long, as a sole proprietor, owned and operated Las Olas Tower Company, Inc. (LOTC), which was created to design and build a luxury high-rise condominium called the Las Olas Tower.
- In 1995, Steelervest, Inc. (Steelervest) entered into a contract to loan funds to LOTC for the development of Las Olas Tower.
- In November 2001, Steelervest purchased Long's interest in Alhambra Joint Ventures (AJV), forgiving previous loans to LOTC, and Long agreed to pay Steelervest $600,000 (or 20% of net profit) if he sold his interest in the Las Olas Tower project.
- In 2002, Long, on behalf of LOTC, entered into an agreement with Las Olas Riverside Hotel (LORH) to buy land for $8,282,800, with a closing date of December 31, 2004.
- In March 2004, LORH unilaterally terminated the contract, leading LOTC to file suit in Florida state court against LORH for specific performance and damages.
- In November 2005, the state court entered judgment in favor of LOTC, ordering LORH to honor the agreement and proceed with the sale, which LORH then appealed.
- In August 2006, during the appeal, Steelervest and Long renegotiated their AJV Agreement, with Long agreeing to pay Steelervest 50% of the first $1.75 million (up to $875,000) received from the Riverside Agreement litigation.
- On September 13, 2006, Long sold his position as plaintiff in the Riverside Agreement lawsuit to Louis Ferris, Jr. for $5,750,000, and subsequently paid Steelervest $600,000 in exchange for a release of all rights under the renegotiated agreement.
Procedural Posture:
- In October 2007, Philip Long filed his federal income tax return for 2006.
- In September 2010, the Internal Revenue Service (IRS) served Long with a notice of deficiency for his 2006 taxes.
- Long filed a pro se petition in the United States Tax Court seeking a redetermination of his deficiency.
- The IRS filed an answer denying any error in the notice of deficiency.
- In April 2012, the Tax Court held a trial.
- Long submitted a post-trial brief, and the IRS submitted a post-trial brief.
- The United States Tax Court rejected Long's arguments and found him liable for a tax deficiency of $1,430,743.
- Philip Long (Petitioner-Appellant) appealed the Tax Court's final order and decision to the United States Court of Appeals for the Eleventh Circuit (Respondent-Appellee).
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Issue:
Does a lump-sum payment received from the assignment of a plaintiff's position in a lawsuit, which grants the assignee the right to acquire property and pursue a development project, constitute taxable ordinary income or a long-term capital gain under 26 U.S.C. § 1221? Additionally, did the Tax Court err in determining that a $600,000 payment was a non-deductible loan repayment and that alleged unaccounted legal fees were not deductible?
Opinions:
Majority - PER CURIAM
No, the $5.75 million Long received from the assignment of his position in the lawsuit constituted long-term capital gains, not ordinary income. Yes, the Tax Court correctly concluded that the $600,000 payment to Steelervest was a non-deductible loan repayment. And no, the Tax Court did not err in rejecting a deduction for additional legal fees. The Eleventh Circuit reversed the Tax Court's decision regarding the characterization of the $5.75 million payment, finding that the Tax Court erred by misconstruing the 'property' subject to capital gains analysis. The court determined that Long did not sell the land itself, which he never owned, but rather his exclusive contractual right to purchase the land, a distinct contractual right that may be a capital asset. The dispositive inquiry was whether Long held this exclusive right primarily for sale to customers in the ordinary course of his business, and the record indicated he intended to fulfill the agreement and develop the project himself, not assign his litigation position. Furthermore, the court rejected the IRS's argument that the 'substitute for ordinary income doctrine' applied. The court distinguished between selling a right to earned income or a fixed amount of future income (which would be ordinary income) and selling a right to create future undetermined income through one's actions. Long's profit represented the sale of a 'bundle of rights' to finish developing a project and earn future income from it, which reflected more than just an opportunity to obtain periodic receipts of income. Taxing the sale of such a right at the highest rate would discourage beneficial economic development. On the second issue, the court affirmed the Tax Court's decision regarding the $600,000 payment to Steelervest. Long failed to meet his burden of clearly establishing his entitlement to deduct the payment. The court found that the Amended AJV Agreement renegotiated Long's indebtedness, making the payment a non-deductible loan repayment. Long also provided no statutory support for a deduction based on 'profit participation.' Finally, the court affirmed the Tax Court's decision on the unaccounted legal fees. Long explicitly abandoned this issue at trial, though the Tax Court addressed it in its final decision. The only evidence Long presented, a letter from his attorneys, was inadmissible hearsay and insufficient to demonstrate entitlement to the deduction.
Analysis:
This case clarifies the application of the 'substitute for ordinary income doctrine' under 26 U.S.C. § 1221, emphasizing that the sale of a right to create future, undetermined income through one's actions, even if that eventual income would be ordinary, can qualify for capital gains treatment. It distinguishes such a right from the sale of an already earned or fixed future income stream, which would be treated as ordinary income. This distinction encourages transfers of property rights that enable economic development by affording favorable tax treatment to sales of entrepreneurial opportunities rather than merely pre-existing income streams. The case also reinforces the taxpayer's strict burden of proof for tax deductions and the rules of evidence in Tax Court.
