Opinion ID: 3023391
Heading Depth: 4
Heading Rank: 1

Heading: Type of carve-out

Text: 4 We borrow these factors from Thomas Sinclair’s comment, see Sinclair, supra, at 401–03, but we differ from him slightly in the way we apply the character factor. 16 The notion of the carve-out, or partial sale, has significant explanatory power in the context of the Hort–Lake line of cases. As Marvin Chirelstein writes, the “‘substitute’ language, in the view of most commentators, was merely a short-hand way of asserting that carved-out interests do not qualify as capital assets.” Marvin A. Chirelstein, Federal Income Taxation ¶ 17.03, at 369–70 (9th ed. 2002). There are two ways of carving out interests from property: horizontally and vertically. A horizontal carve-out is one in which “temporal divisions [are made] in a property interest in which the person owning the interest disposes of part of his interest but also retains a portion of it.” Sinclair, supra, at 401. In lottery terms, this is what happened in Davis, Boehme, and Clopton—the lottery winners sold some of their future lottery payment rights (e.g., their 2006 and 2007 payments) but retained the rights to payments further in the future (e.g., their 2008 and 2009 payments). See Clopton, 87 T.C.M. (CCH) at 1217–18 (finding that the lottery winner sold only some of his remaining lottery payments); Boehme, 85 T.C.M. (CCH) at 1040 (same); Davis, 119 T.C. at 3 (same). This is also what happened in Hort and Lake; portions of the total interest (a term of years carved out from a fee simple and a three-year payment right from a working interest in a oil lease, respectively) were carved out from the whole. A vertical carve-out is one in which “a complete disposition of a person’s interest in property” is made. Sinclair, 17 supra, at 401. In lottery terms, this is what happened in Watkins and Maginnis—the lottery winners sold the rights to all their remaining lottery payments. See Maginnis, 356 F.3d at 1181 (noting that the lottery winner assigned his right to receive all his remaining lottery payments); Watkins, 88 T.C.M. (CCH) at 391 (same). Horizontal carve-outs typically lead to ordinary-income treatment. See, e.g., Maginnis, 356 F.3d at 1185–86 (“Maginnis is correct that transactions in which a tax-payer transfers an income right without transferring his entire interest in an underlying asset will often be occasions for applying the substitute for ordinary income doctrine.”). This was also the result reached in Hort and Lake. Lake, 356 U.S. at 264; Hort, 313 U.S. at 32. Vertical carve-outs are different. In Dresser Industries, for example, the Fifth Circuit distinguished Lake because the taxpayer in Dresser had “cut[] off a ‘vertical slice’ of its rights, rather than carv[ed] out an interest from the totality of its rights.” Dresser Indus., 324 F.2d at 58. But as the results in Maginnis and Watkins demonstrate, a vertical carve-out does not necessarily mean that the transaction receives capital-gains treatment. See, e.g., Maginnis, 356 F.3d at 1185 (holding “that a transaction in which a taxpayer sells his entire interest in an underlying asset without retaining any property right does not automatically prevent application of the substitute for ordinary income doctrine” (emphasis in original)); see also id. at 1186. 18 Because a vertical carve-out could signal either capitalgains or ordinary-income treatment, we must make another determination to conclude with certainty which treatment should apply. Therefore, when we see a vertical carve-out, we proceed to the second factor—character of the asset—to determine whether the sale proceeds should be taxed as ordinary income or capital gain.