Definition — Capital or Ordinary?

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Image source: PuzzleID: 197178 © Johanna Goodyear Dreamstime Stock Photos

Image source: PuzzleID: 197178 © Johanna Goodyear Dreamstime Stock Photos

For tax purposes, the answer to the “capital or ordinary” question seems simple enough for income. Ordinary income includes any gain from the sale or exchange of property that is not a capital asset (Internal revenue code section 64). Capital gain results from gain on the sale or exchange of a capital asset (Internal revenue code section 1222).

Simple can still be puzzling. The dilemma, as always, lies in the details; the solution in putting the pieces together.

In T.C. Summary Opinion 2014-22 (Kamieneski), the taxpayer developed a business model. He did not apply for a copyright or patent for the business model, but signed an agreement with a technology company and provided the business model to the company in exchange for $22,500. He received the money in installments.

The taxpayer says the income is capital gain. The IRS says the income is ordinary.

According to the tax court, the issue comes down to whether the transaction resulted in a sale or whether it was a licensing arrangement.

The determination means deciding if “substantial rights” were transferred as part of the agreement. The term “substantial rights” is defined as all rights of value at the time the rights (or an undivided interest in the rights) are transferred. For example, exclusive licenses to manufacture, use, and sell are considered sales or exchanges because all right, title, and interest is transferred.

Here are the relevant parts of the agreement considered by the tax court in this case.

WHEREAS taxpayer has created enterprise value for technology company in the form of Goodwill and certain Business Model and Business Practice Innovations; and

WHEREAS taxpayer and technology company have determined it is in their respective best interests to establish a single dollar value for these technology company assets provided by taxpayer.

NOW, THEREFORE, for and in consideration of the mutual promises and agreements contained herein and in consideration of the payments to taxpayer as provided in this Agreement, the sufficiency of which is hereby acknowledged, technology company and taxpayer hereby agree to the following:

1. Consideration.

(a) Technology company agrees to pay taxpayer the sum of $22,500 in six equal installments of $3,750 to be paid on or before the last day of October, November, December (2008), January, February and March (2009).

(b) Taxpayer agrees to accept the consideration described in this Paragraph No. 1 as full, complete and adequate consideration for taxpayer provision to technology company of the aforementioned Goodwill and Business Model Innovations.

2. Release and Indemnification.

Technology company and taxpayer release, indemnify and forever discharge the other from any and all claims pertaining to the aforementioned Goodwill and Business Model Innovations.

How do you think the court decided? For the or for the

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For the IRS.

For a transaction to receive capital gains treatment, the property which is transferred must be sold or exchanged. It is frequently necessary to determine whether a variety of conditions included in an agreement between the transferor and the transferee transforms a purported sale into a license, thus requiring the gains from the transaction to be taxed as ordinary income. When an agreement is interpreted as reserving significant powers, rights, or continuing interests to the transferor, then it has been held that such reservations preclude a finding of a sale.

In order for the transfer of the client methodology to be deemed a sale for tax purposes, the taxpayer must establish that he surrendered all substantial rights of value in the client methodology; otherwise, the transfer is deemed to be a license.

In this case, the agreement itself does not contain terms that would suggest exclusivity in the transfer upon execution of the agreement. Upon examining the terms of the agreement, we conclude the parties did not intend that the taxpayer transfer all substantial rights of value in the client methodology.

We base our conclusion on the fact that the agreement contains no terms preventing the taxpayer from disclosing the client methodology to other persons or entities. Although the taxpayer claims that he developed the client methodology and gave up all rights to that methodology to the technology company, the contract he entered into does not confer exclusivity in the client methodology.

Given the nature and terms of the agreement, we conclude the taxpayer did not grant exclusivity in the client methodology. Therefore, provision of the client methodology did not amount to a sale and the remuneration received for the provision of the client methodology is considered ordinary income.

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