Opinion ID: 77887
Heading Depth: 1
Heading Rank: 4

Heading: Effect of Arkansas Best

Text: We briefly address Taxpayers' argument that the Supreme Court's decision in Arkansas Best Corp. v. Comm'r, 485 U.S. 212, 108 S.Ct. 971, 99 L.Ed.2d 183 (1988), significantly limited the substitute for ordinary income doctrine. Like other courts that have confronted it, we reject this contention. Maginnis, 356 F.3d at 1185; Lattera, 437 F.3d at 403-04; Davis, 119 T.C. at 6; Gladden v. Comm'r, 112 T.C. 209, 221, 1999 WL 218904 (1999), rev'd on other grounds, 262 F.3d 851 (9th Cir.2001); FNMA v. Comm'r, 100 T.C. 541, 573 & n. 30, 1993 WL 210390 (1993). The Arkansas Best Court discussed the substitute for ordinary income doctrine in a footnote. [7] The footnote reads, in full: Petitioner mistakenly relies on cases in which this Court, in narrowly applying the general definition of capital asset, has construed `capital asset' to exclude property representing income items or accretions to the value of a capital asset themselves properly attributable to income, even though these items are property in the broad sense of the word. United States v. Midland-Ross Corp., 381 U.S. 54, 57, 85 S.Ct. 1308, 1310, 14 L.Ed.2d 214 (1965). See, e.g., Comm'r v. Gillette Motor Transport, 364 U.S. 130, 80 S.Ct. 1497, 4 L.Ed.2d 1617 (1960) (capital asset does not include compensation awarded taxpayer that represented fair rental value of its facilities); Comm'r v. P.G. Lake, Inc., 356 U.S. 260, 78 S.Ct. 691, 2 L.Ed.2d 243 [sic] (1958) (capital asset does not include proceeds from sale of oil payment rights); Hort v. Comm'r, 313 U.S. 28, 61 S.Ct. 757, 85 L.Ed. 1168 (1941) (capital asset does not include payment to lessor for cancellation of unexpired portion of a lease). This line of cases, based on the premise that § 1221 property does not include claims or rights to ordinary income, has no application in the present context. Petitioner sold capital stock, not a claim to ordinary income. Ark. Best, 485 U.S. at 217 n. 5, 108 S.Ct. at 975 n. 5 (emphasis added and citation formatting modified). This footnote affirmed that the substitute for ordinary income doctrine applies to property that represents a claim to ordinary income. Taxpayers urge a different interpretation. They focus on the Court's use of the word narrowly and insist that the factual scenarios corresponding to the four Supreme Court cases cited in the footnote, Hort, Lake, Gillette, and Midland-Ross, are the only surviving remnants of the substitute for ordinary income doctrine. They argue that because the footnote directly clashes with the body of the opinion . . . the only logical reading of the use of the term `narrowly' in footnote 5 is that only in those particular ` narrow ' factual situations that existed in the cited cases is the [d]octrine applicable. (Br. for the Appellants 42.) Taxpayers' reading is not the natural one. In the footnote, the word narrowly modifies the phrase that immediately follows, applying the general definition of `capital asset.' The footnote unambiguously explains that in the cited cases, the Court applied the statutory definition of capital asset narrowly. It in no way implies that the Court applied the substitute for ordinary income doctrine narrowly, nor hints that the Court would confine the doctrine to the facts of the cases it cites. To the contrary, the Court cites general language that indicates that it would apply the doctrine in any situation involving `income items or accretions to the value of a capital asset themselves properly attributable to income.' Ark. Best, 485 U.S. at 217 n. 5, 108 S.Ct. at 975 n. 5 (quoting Midland-Ross, 381 U.S. at 57, 85 S.Ct. at 1310). We have no trouble reconciling this footnote with the body of the Arkansas Best opinion for the reasons stated in the footnote itself: the taxpayer in that case sold capital stock, not a claim to ordinary income. Id. We reject Taxpayers' attempt to limit the substitute for ordinary income doctrine in an unreasonable manner not suggested by the relevant case law. This is not to say that the substitute for ordinary income doctrine applies upon the sale of every asset that produces ordinary income. Taken to its logical extreme, the substitute for ordinary income doctrine would obliterate capital gains treatment altogether because a capital asset's present value is often based on its future ability to produce revenue in the form of ordinary income. Maginnis, 356 F.3d at 1182. We acknowledge that the doctrine has its outer limits, but we do not define them here. We merely recognize that Arkansas Best did not circumscribe the substitute for the ordinary income doctrine. See, e.g., Maginnis, 356 F.3d at 1185; Lattera, 437 F.3d at 403-04.
As Taxpayers note, Arkansas Best makes clear that if a given asset is not listed within Section 1221's exclusions, it is a capital asset unless it is not considered property. Ark. Best, 485 U.S. at 217-18, 108 S.Ct. at 975. The pertinent Treasury Department regulation also provides that [t]he term capital assets includes all classes of property not specifically excluded by section 1221. 26 C.F.R. § 1.1221-1(a). The parties do not dispute that Lottery Rights are not within the statutory exclusions. Therefore, in deciding that the substitute for ordinary income doctrine applies, we necessarily find that Lottery Rights do not constitute property as that term is used in Section 1221. 4 Mertens Law of Federal Income Taxation § 22:4 (Sept.2007) [hereinafter Mertens ] (In situations where the court determines that the intangible right is a substitute for ordinary income, the court concludes (either implicitly or explicitly) that the asset sold does not constitute property for purposes of Section 1221.). Taxpayers also note that Lottery Rights are property in the ordinary sense of the term and for purposes of other state and federal laws. We recognize that Lottery Rights are property for most other purposes, but property under Section 1221 is a narrower concept. Gillette, 364 U.S. at 134-35, 80 S.Ct. at 1500-01; Mertens, supra, § 22:4 (The mere fact, however, that the asset in question constitutes `property' in the broad sense of the word does not mean that such asset constitutes property for purposes of Section 1221 or that the property constitutes a capital asset.); Note, Distinguishing Ordinary Income from Capital Gain Where Rights to Future Income are Sold, 69 Harv. L.Rev. 737, 737-38 (1956) (`Property,' as it is broadly used in other areas of the law, includes such items as unpaid claims for personal services or for accrued rents. Unless Congress intended that holders of such claims to ordinary income would be able by selling them to transform ordinary income into capital gain, `property' for the purposes of section 1221 is a more limited concept.). As the Supreme Court has stated, it is evident that not everything which can be called property in the ordinary sense and which is outside the statutory exclusions qualifies as a capital asset. Gillette, 364 U.S. at 134, 80 S.Ct. at 1500. [8] The Court again recognized in Arkansas Best, that a literal reading of the term property is not appropriate where such a reading would include ordinary income and substitutes for ordinary income. See Ark. Best, 485 U.S. at 217 n. 5, 108 S.Ct. at 975 n. 5 (describing the assets falling within the substitute for ordinary income doctrine as property in the broad sense of the word); see also Donna D. Adler, A Conversational Approach to Statutory Analysis: Say What You Mean & Mean What You Say, 66 Miss. L.J. 37, 106 (1996) (If the literal language of [Section 1221] were followed, taxpayers could convert much of their ordinary income to capital gain merely by selling the right to the income before the payment was actually made.). This interpretation, which courts repeatedly adopt, gives effect to congressional intent. In defining capital asset, Congress used the term property to mean not income  that is, property serves to distinguish assets suitable for capital gains treatment from mere income. Property in the most general sense means anything owned, which would also include income and any rights or claims to it. Even if other statutes use property in this broad sense, to exclude substitutes for income in determining what constitutes a capital asset is consistent with the word property. No other interpretation of property would harmonize with the statute's purpose, as the very nature of the term capital asset excludes what is in essence ordinary income. See Stanley S. Surrey, Definitional Problems in Capital Gains Taxation, 69 Harv. L.Rev. 985, 987-88 (1956) (Since in one sense everything that the taxpayer holds is `property' and hence will be a capital asset, at this point it would seem to follow that all income could well be `capital gain'. . . .). Indeed, in applying the substitute for ordinary income doctrine, the Gillette court declined to use the all-inclusive definition of property the Supreme Court espoused in one of its earlier decisions, Crane v. Comm'r, 331 U.S. 1, 6, 67 S.Ct. 1047, 1051, 91 L.Ed. 1301 (1947) (interpreting property as anything subject to ownership). Rather, the Gillette court confirmed that some things that would normally be property are not capital assets, even if no statutory exclusion covers them. Gillette, 364 U.S. at 134, 80 S.Ct. at 1500. Lottery Rights, as we explained above, are substitutes for ordinary income. We now address two of Taxpayers' arguments related to specific types of property.
Taxpayers argue that Lottery Rights are property because they are accounts receivable. Section 1221 excludes from the definition of capital asset certain types of accounts receivable, specifically accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1). 26 U.S.C. § 1221(a)(4). The exclusion of business-related accounts receivable, according to Taxpayers, implies that all other types of accounts receivable are property, because otherwise that exclusion would be surplusage. Taxpayers' primary support for their argument that Lottery Rights are accounts receivable comes from the Uniform Commercial Code, which defines account to include rights to payment as winnings in a lottery or other game of chance operated or sponsored by a State. U.C.C. § 9-102(a)(2). But the Internal Revenue Code does not define accounts receivable. As the Fifth Circuit stated in a case involving contractual rights in a mortgage servicing agency, [t]he fact that [those rights] constitute a species of `property' under state law affords no assistance in determining whether such rights are capital assets. Bisbee-Baldwin Corp. v. Tomlinson, 320 F.2d 929, 932 (5th Cir.1963); see also Miller v. Comm'r, 299 F.2d 706, 708 (2d Cir. 1962) (noting that although ordinary property concepts are relevant, non-tax definitions are certainly not binding on a court interpreting Section 1221). In any event, the status of Lottery Rights as accounts receivable is a separate question from whether Lottery Rights fall under the substitute for ordinary income doctrine. As the Maginnis court stated: Although some accounts receivable not covered by 1221(a)(4)'s exception will be capital assets, under the substitute for ordinary income doctrine, some will not be capital assets. Assuming without deciding that Maginnis' lottery right was an account receivable, that fact does not affect our analysis. Maginnis, 356 F.3d at 1187 n. 9. In other words, even if a certain asset is classified as a non-business-related account receivable, the application of the substitute for ordinary income doctrine is not necessarily precluded, if the asset is otherwise a substitute for ordinary income under the principles of the doctrine. We acknowledge the merits of Taxpayers' statutory interpretation argument. But in order to effect congressional intent, courts applying the substitute for ordinary income doctrine sometimes reach a different result than they would applying bare interpretive canons without context. See In re Griffith, 206 F.3d 1389, 1393 (11th Cir.2000) (explaining that canons of construction `are no more than rules of thumb that help courts determine the meaning of legislation.') (quoting Conn. Nat'l Bank v. Germain, 503 U.S. 249, 253, 112 S.Ct. 1146, 1149, 117 L.Ed.2d 391 (1992)). The substitute for ordinary income doctrine prioritizes substance over form to eliminate capital gains treatment in situations involving claims for ordinary income. See Lake, 356 U.S. at 266, 78 S.Ct. at 695 (The substance of what was assigned was the right to receive future income.). Congress did not intend to tax lottery winnings as capital gains. Thus, whether or not Lottery Rights are accounts receivable, they are not capital assets under Section 1221. [9]
Finally, we are unpersuaded by Taxpayers' argument that Lottery Rights are debt instruments under 26 U.S.C. § 1275. That section defines debt instrument as a bond, debenture, note, or certificate or other evidence of indebtedness. 26 U.S.C. § 1275(a)(1)(A). Taxpayers argue that Lottery Rights are property, and therefore capital assets, because they are evidence of indebtedness. [10] In confronting the same argument, the Maginnis court cited Deputy v. du Pont, 308 U.S. 488, 498, 60 S.Ct. 363, 368, 84 L.Ed. 416 (1940), in which the Supreme Court stated that `interest on indebtedness' means compensation for the use or forbearance of money. Maginnis, 356 F.3d at 1187. For example, an individual borrowing money from a bank pays interest to the bank in exchange for having access to the bank's money up front. The Maginnis court stated that a lottery winner receive[s] his right to payments from the state . . . as a prize, not as any compensation for the use or forbearance of money, and therefore the lottery right d[oes] not constitute evidence of an indebtedness from [the state] to [the lottery winner]. Id. We agree. That Lottery Rights are traded in the financial marketplace is irrelevant to an asset's characterization under Section 1275. In determining whether Lottery Rights are evidence of indebtedness, we look to the party allegedly indebted, here the state of Florida. Florida incurred no debt when it undertook the obligation to make prize payments to lottery winners. The lottery winners won a game of chance, for which they were awarded a certain amount of money to be paid annually. They lent no money to Florida, and made no promise to Florida to use money, or to refrain from using money. Lottery Rights are thus not evidence of Florida's indebtedness to Taxpayers, nor debt instruments under Section 1275.