Opinion ID: 3023391
Heading Depth: 4
Heading Rank: 2

Heading: Character of the asset

Text: The Fifth Circuit in Dresser Industries noted that “[t]here is, in law and fact, a vast difference between the present sale of the future right to earn income and the present sale of the future right to earned income.” Dresser Indus., 324 F.2d at 59 (emphasis in original). The taxpayer in Dresser Industries had assigned its right to an exclusive patent license back to the patent holder in exchange for a share of the licensing fees from third-party licensees. Id. at 57. The Court used this “right to earn income”/“right to earned income” distinction to hold that capital-gains treatment was applicable. It noted that the asset sold was not a “right to earned income, to be paid in the future,” but was “a property which would produce income.” Id. at 59. Further, it disregarded the ordinary nature of the income generated by the asset; because “all income-producing property” produces ordinary income, the sale of such property does not result in ordinary-income treatment. Id. (This can be seen in the sale of stocks or bonds, both of which produce ordinary income, but the sale of which is treated as capital gain.) 19 Sinclair explains the concept in this way: “Earned income conveys the concept that the income has already been earned and the holder of the right to this income only has to collect it. In other words, the owner of the right to earned income is entitled to the income merely by virtue of owning the property.” Sinclair, supra, at 406. He gives as examples of this concept rental income, stock dividends, and rights to future lottery payments. Id.; see also Rhodes’ Estate v. Comm’r, 131 F.2d 50, 50 (6th Cir. 1942) (per curiam) (holding that a sale of dividend rights is taxable as ordinary income). For the right to earn income, on the other hand, “the holder of such right must do something further to earn the income. . . . [because] mere ownership of the right to earn income does not entitle the owner to income.” Sinclair, supra, at 406. Following Dresser Industries, Sinclair gives a patent as an example of this concept. Id. Assets that constitute a right to earn income merit capitalgains treatment, while those that are a right to earned income merit ordinary-income treatment. Our Court implicitly made this distinction in Tunnell v. United States, 259 F.2d 916 (3d Cir. 1958). Tunnell withdrew from a law partnership, and he assigned his rights in the law firm in exchange for $27,500. Id. at 917. When he withdrew, the partnership had over $21,000 in uncollected accounts receivable from work that had already been done. Id. We agreed with the District Court that “the sale of a partnership is treated as the sale of a capital asset.” Id. The sale of a partnership does not, in and of itself, confer income on the 20 buyer; the buyer must continue to provide legal services, so it is a sale of the right to earn income. Consequently, as we held, the sale of a partnership receives capital-gains treatment. The accounts receivable, on the other hand, had already been earned; the buyer of the partnership only had to remain a partner to collect that income, so the sale of accounts receivable is the sale of the right to earned income. Thus, we held that the portion of the purchase price that reflected the sale of the accounts receivable was taxable as ordinary income. Id. at 919. Similarly, when an erstwhile employee is paid a termination fee for a personal-services contract, that employee still possesses the asset (the right to provide certain personal services) and the money (the termination fee) has already been “earned” and will simply be paid. The employee no longer has to perform any more services in exchange for the fee, so this is not like Dresser Industries’s “right to earn income.” These termination fees are therefore rights to earned income and should be treated as ordinary income. See, e.g., Elliott v. United States, 431 F.2d 1149, 1154 (10th Cir. 1970); Holt v. Comm’r, 303 F.2d 687, 690 (9th Cir. 1962); see also Chirelstein, supra, ¶ 17.03, at 376–77 (noting that “courts have held consistently that payments made to an employee for the surrender of his employment contract are ordinary”). The factor also explains, for example, the Second Circuit’s complex decision in Commissioner v. Ferrer, 304 F.2d 125 (2d Cir. 1962). The actor José Ferrer had contracted for the 21 rights to mount a stage production based on the novel Moulin Rouge. Id. at 126. In the contract, Ferrer obtained two rights relevant here: (1) the exclusive right to “produce and present” a stage production of the book and, if the play was produced, (2) a share in the proceeds from any motion-picture rights that stemmed from the book. Id. at 127. After a movie studio planned to make Moulin Rouge into a movie—and agreed that it would feature Ferrer—he sold these, along with other, rights. Id. at 128–29. Right (1) would have required Ferrer to have produced and presented the play to get income, so it was a right to earn income—thus, capital-gains treatment was indicated. Right (2), once it matured (i.e., once Ferrer had produced the play), would have continued to pay income simply by virtue of Ferrer’s holding the right, so it would have become a right to earned income—thus, ordinary-income treatment was indicated. The Second Circuit held as such, dictating capital-gains treatment for right (1) and ordinary-income treatment for right (2). Id. at 131, 134.5 5 One well-known result that these factors do not predict is the Second Circuit’s 1946 opinion in McAllister v. Commissioner, 157 F.2d 235 (2d Cir. 1946). In that case, a widow was forced to sell her life estate in a trust to the remainderman. Id. at 235. Thus, she received a lump-sum payment in exchange for her right to all future payments from the trust. Although this was a vertical carve-out, susceptible to both types of treatment, she gave up her right to earned income, because she would have continued receiving payments simply 22 E. Application of the “family resemblance” test Applied to this case, the “family resemblance” test draws out as follows. First, we try to determine whether an asset is like either the “capital asset” category of assets (e.g., stocks, bonds, or land) or like the “income items” category (e.g., rental income or interest income). If the asset does not bear a family resemblance to items in either of those categories, we move to the following factors. by holding the life estate. Thus, the sale proceeds should have received ordinary-income treatment. The Court held instead that capital-gains treatment was indicated. Id. at 236. But the result in McAllister has been roundly criticized. The Tax Court in that case had held that ordinary-income treatment was proper, id. at 235, and Judge Frank entered a strong dissent, id. at 237–41 (Frank, J., dissenting). The McAllister Court relied on a case that did not even discuss the capital-asset statute. Id. at 237 (majority opinion). Chirelstein writes that the “decision in McAllister almost certainly was wrong.” Chirelstein, supra, ¶ 17.03, at 373. And a 2004 Tax Court opinion did not even bother to distinguish McAllister, stating simply that it was “decided before relevant Supreme Court decisions applying the substitute for ordinary income doctrine” (referring, inter alia, to Lake). Clopton, 87 T.C.M. (CCH) at 1219. We consider McAllister to be an aberration, and we do not find it persuasive in our decision in this case. 23 We look at the nature of the sale. If the sale or assignment constitutes a horizontal carve-out, then ordinaryincome treatment presumably applies. If, on the other hand, it constitutes a vertical carve-out, then we look to the character-ofthe-asset factor. There, if the sale is a lump-sum payment for a future right to earned income, we apply ordinary-income treatment, but if it is a lump-sum payment for a future right to earn income, we apply capital-gains treatment. Turning back to the Latteras, the right to receive annual lottery payments does not bear a strong family resemblance to either the “capital assets” or the “income items” listed at the polar ends of the analytical spectrum. The Latteras sold their right to all their remaining lottery payments, so this is a vertical carve-out, which could indicate either capital-gains or ordinaryincome treatment. But because a right to lottery payments is a right to earned income (i.e., the payments will keep arriving due simply to ownership of the asset), the lump-sum payment received by the Latteras should receive ordinary-income treatment. This result comports with Davis and Maginnis. It also ensures that the Latteras do not “receive a tax advantage as compared to those taxpayers who would simply choose originally to accept their lottery winning in the form of a lump 24 sum payment,” something that was also important to the Maginnis Court. Maginnis, 356 F.3d at 1184.6