Academic journal article Journal of Accountancy

Refining the Definition of a Capital Asset

Academic journal article Journal of Accountancy

Refining the Definition of a Capital Asset

Article excerpt

Section 1221 of the tax code broadly defines a capital asset. Over time the courts have attempted to narrow that definition and eliminate confusion. Recently a Third Circuit Court of Appeals ruling brought further clarification.

In June 1991 George and Angeline Lattera purchased a Pennsylvania lottery ticket for $1 and won $9,595,326. In September 1999 they received court approval to sell the rights to the remaining 17 annual payments of $369,051 for $3,372,342. They reported this transaction as a long-term capital gain. The IRS reclassified it as ordinary income and assessed a $660,784 deficiency. The taxpayers petitioned the Tax Court to eliminate the deficiency; the court sided with the IRS. The couple then appealed to the Third Circuit.

Result. For the IRS. Both the Tax Court and the Ninth Circuit Court of Appeals have ruled that the sale of lottery winnings generates ordinary income. Because of the harsh criticism of these decisions, the Third Circuit reexamined the issue to clarify what property qualifies as a capital asset.

In Hort and Lake, the Supreme Court narrowed the definition of capital asset by establishing the "substitute for ordinary income" exception. Under this exception, the sale of property that generates a receipt which is a substitute for future ordinary income is not a sale of a capital asset. It has been suggested that the Supreme Court's 1988 decision in Arkansas Best rejected this exception. Although most courts do not fully discuss the exemption's limits or reconcile differences in prior decisions, they find that the exception survived the Arkansas Best holding.

In the current case, the Third Circuit provided an analytical framework for addressing this issue. According to the appeals court, certain assets (stocks, bonds and options) are clearly capital and others (interest and rent) are unmistakably ordinary income. When disputes arise, a court should consider the nature of the property. If the property more closely resembles a capital asset, it is capital; if it more closely resembles ordinary income property, it is ordinary income. …

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