Indiana Law Review


Indiana Lair Revieiiv
Volume 13 1980 Number 2

Reexamining the Relationship Between Capital Gain
and the Assignment of Income

David F. Shores*

I. Introduction

Only gain from the sale or exchange of property qualifies for

preferential capital gain treatment under the Internal Revenue Code
(IRC)/ When an interest is sold the question sometimes arises
whether the interest is a property interest qualifying for capital

gain treatment, or an income interest which is not a capital asset

because it is not "property" within the meaning of section 1221 of
the Code. The property versus income distinction is also crucial to
the assignment of income doctrine, which states that only property,

not income, can be transferred by gift for income tax purposes.^ If

an interest believed to be a property interest is transferred by gift

and is later found to be an income interest, the transfer will be

disregarded for tax purposes and the transferor taxed on the in-

come. For example, a fee owner of real estate might give his child
the right to collect rent from the real estate for a five-year period.

Although the child may have an enforceable right to the rent under
local law, the assignment of income doctrine precludes recognition of

the transfer and therefore the donor will be taxed on the income. If,

Professor of Law, Wake Forest University School of Law. B.B.A. University of
Iowa, 1965; J.D., University of Iowa, 1967; L.L.M., Georgetown Law Center, 1969.

^I.R.C. §§ 1221, 1222. See also id. §§ 1201-1202, 1221-1222.

^Compare Blair v. Commissioner, 300 U.S. 5 (1937) (life estate in trust may be
assigned by gift), with Helvering v. Horst, 311 U.S. 112 (1940) (interest coupons de-

tached from bonds cannot be assigned by gift). Under the grantor trust rules, an in-

come interest of 10 years or more may be assigned through a 10-year trust and the
donee will be taxed on the income. I.R.C. §§ 671-677. A mere right to income, however,
cannot be assigned for tax purposes. To qualify under the grantor trust rules, the in-
terest assigned to the trust must be a property interest. Treas. Reg. § 1.671-l(c), T.D.

7148, 1971-2 C.B. 251. If the conditions of the grantor trust rules are met, the income

from such property will be taxed to the donee-beneficiary during the term of the trust.

For a comprehensive discussion of the assignment of income doctrine, see Lyon

& Eustice, Assignment of Income: Fruit and Tree as Irrigated by the P.G. Lake Case,
17 Tax L. Rev. 293 (1962).

463



464 INDIANA LA W REVIEW [Vol. 13:463

however, the fee owner gave away the fee, the transfer of a proper-
ty interest would be effective for tax purposes, and income accruing

after the date of the gift would be taxed to the donee.

The income versus property issue is not new to federal taxation.
One issue debated in Congress prior to adoption of the first perma-
nent income tax was whether an income tax on rents was actually a
tax on the rental property.^ If so, it was argued, the Constitution re-
quired the tax to be apportioned among the states according to
population.* Because an income tax could not be so apportioned, the

Supreme Court declared the tax unconstitutional in Pollock v.
Farmers* Loan & Trust Co.^ The Court could not resist the notion
that a tax on income derived from property is intrinsically the same
as a tax on the property itself. This facet of the income versus prop-

erty issue was laid to rest in 1913 with the adoption of the sixteenth
amendment which authorized Congress to tax all income *'from
whatever source derived, without apportionment among the several
states."

This Article will examine the decisional law dealing with the in-

come versus property issue, with particular focus on the relationship
between capital gain and gift cases. For example, if a gratuitous
assignment of rent is disregarded for tax purposes, does it

necessarily follow that a sale of a right to rent should be treated as

the sale of an income interest taxable at ordinary rather than

capital rates?

It is important to note at the outset that although the verbal

formulation of the issue is the same in capital gain and assignment
of income cases, that is, whether a property interest or an income

interest was transferred,® the purposes for distinguishing property
from income in these two categories of cases are quite different. The
principal justification for the present scheme of capital gain taxation
is that it mitigates the harsh effects of a progressive rate structure

on appreciation accrued over a long period of time but realized in a

^26 Cong. Reg. 6826-27 (1894).

*"No Capitation or other direct, Tax shall be laid, unless in Proportion to the

Census or Enumeration herein before directed to be taken." U.S. Const, art. I, § 9, cl.

4. It was generally assumed that a property tax of the type commonly used today by

counties and municipalities was a direct tax subject to the apportionment clause.

n57 U.S. 429, aff'd on reheaHng, 158 U.S. 601 (1895).

*In some capital gain cases, the courts have focused upon whether a sale or ex-

change has occurred. Under this analysis, capital gain treatment depends upon

whether the transferor sold his entire interest in the property. If he retained an in-

terest, there is no sale and capital gain treatment is denied. Of course, an identical

result could be achieved by analysis of what was transferred. A transfer of less than
the entire interest in the property is a transfer of an income interest rather than a

transfer of property. See text accompanying note 58 infra.



1980] CAPITAL GAIN 465

single year.^ This bunching of income problem could, of course, be

dealt with in other ways, such as averaging the gain over the

holding period of the asset or requiring recognition of appreciation

which has not been realized through a sale or exchange.^ The com-
parative merits of these possibilities are not considered here. Con-

gress has chosen to deal with the bunching problem by taxing

capital gains at a lower rate than ordinary income. In deciding

whether a given item is a property interest qualifying for capital

gain treatment or an income interest which does not qualify, it is ap-

propriate to keep that legislative purpose in mind.

The principal justification for the assignment of income doctrine

is to preserve rather than ameliorate the effect of progressive taxa-

tion. If a parent with total taxable income of $100,000 could assign

$25,000 to a child, total taxes would be reduced even though the

child is taxed on the amount he received because neither would pay

tax at the rate applicable to $100,000 of taxable income. Before

taxes can be reduced through income splitting, the assignment of in-

come doctrine requires that the source of the income, for example, the

fee simple interest in real estate generating rent, be assigned. If a tax-

payer were permitted to split off and assign a mere income interest,
high rates of taxation could be avoided too easily. Requiring a com-

plete transfer of the donor's entire interest lends substantiality to

the transaction and justifies its recognition for tax purposes.

An important objective of this Article is to identify common
strands running through the cases as an aid in the difficult task of

characterizing borderline transactions for capital gain and assign-

ment of income purposes. The vast majority of interests clearly fall
into either the income or property category. For example, interest

coupons in the hands of a bondholder which represent nothing more

''See Emory, The Corman and Mills-Mansfield Bills: A Look at Some Major Tax
Reform Issues, 29 Tax L. Rev. 3, 94 (1973). Additional justifications sometimes advanced
are unconvincing. See id. at 94-95.

'Whether a tax on unrealized appreciation would be constitutionally permissible

has never been decided by the Supreme Court. The landmark case of Eisner v.
Macomber, 252 U.S. 189 (1920) (holding stock dividends to be outside the scope of in-
come taxable under the sixteenth amendment), generally supports the proposition that
unrealized appreciation cannot be taxed. The continued validity of Eisner v. Macomber
has been questioned. One commentator has suggested that whatever remains of Eisner
V. Macomber "be consigned to the junk yard of judicial history." J. Sneed, The Con-
figurations OF Gross Income 125 (1967). If a scheme could be devised for overcoming

the administrative and judicial problems of taxing unrealized appreciation and Con-

gress chose to adopt it, the Supreme Court would probably uphold it. See Lowndes,
Current'^Conceptions of Taxable Income, 25 Ohio St. L.J. 151 (1964). "Today the

Court's tolerance for the tax has reached the point where it would be very surprising

if anything which there was a reasonable basis for taxing under the income tax was
found to be beyond Congress' constitutional competence." Id. at 153.



466 INDIANA LAW REVIEW [Vol. 13:463

than the right to collect interest clearly represent income and not

property for tax purposes. If they are severed from the bonds and

transferred by gift, the donor will be taxed on the interest collected

by the donee.^ If they are severed from the bonds and sold, the

seller will be taxed at ordinary rather than capital rates.^** It is

equally clear that the bond itself is property, even though it carries

with it the right to collect future interest. ^^ If sold, the gain general-

ly qualifies for capital gain treatment.^^ This Article focuses on cer-

tain types of interests which are problematical. These include

leaseholds; life estates; oil, gas, and mineral interests; franchises;

and personal service contracts. In the interest of convenience and

clarity, the cases are categorized according to the type of interest

involved.

II. Leaseholds

A. Capital Gain Versus Ordinary Income

The characterization question most frequently arises when a
lessor receives something other than rent in connection with a lease.

In Hort V. Commissioner,^^ the seminal decision, the Court denied
capital gain treatment to a lessor who received $140,000 in exchange
for cancellation of a lease which had become onerous to the lessee.
Conceding that the lease was ^'property," the Court concluded that
*'[i]t is immaterial that for some purposes the contract creating the
right to such payments may be treated as 'property' or 'capital.'"^*
For the purpose of applying the capital gain provisions, the Court

held that the lump sum payment was not a return of capital but a
substitute for future rent which would have been taxed as ordinary

income.^^

"Commissioner v. Horst, 311 U.S. 112 (1940).

^^See Shafer v. United States, 204 F. Supp. 473 (S.D. Ohio 1962), aff'd, 312 F.2d

747 (6th Cir. 1963).

"This conclusion is implicit in Commissioner v. Horst, 311 U.S. 112 (1940). The

Court characterized interest coupons as representing income because the bondholder

"separated his right to interest payments from his investment and procured the pay-

ment of the interest to his donee . . . ." Id. at 120.

^*0f course, amounts representing payment for accrued interest are not received

in exchange for property and cannot qualify for capital gain treatment even if received

in connection with sale of the bond. First Ky. Co. v. Gray, 309 F.2d 845 (6th Cir. 1962).

Amounts received for the right to collect principal at maturity and the right to collect
interest accruing between the date of sale and maturity will qualify for capital gain if

the bond is a capital asset (not held for sale to customers in the ordinary course of

business), has been held for more than one year, and was not originally issued at a dis-
count from face value. See I.R.C. §§ 1221-1222, 1232.

"313 U.S. 28 (1941).

''Id. at 31.

"/d. Similar treatment has been accorded a lump sum payment received in ex-



1980] CAPITAL GAIN 467

This substitution analysis looks to the result of applying the

capital gain provisions. If the result is deemed incompatible with the
congressional intent of taxing an item as ordinary income, the item

cannot be property within the meaning of the capital gain provisions

regardless of its characterization under local law. The foregoing

does not mean, however, that all substitutes for ordinary income fail

to qualify for capital gain treatment. The Fifth Circuit has stated:

[Past Supreme Court decisions cannot be interpreted] to
mean that any money paid which represents the present
value of future income to be earned is always taxed as or-

dinary gains. As a legal or economic position, this cannot be
so. The only commerical value of any property is the present
worth of future earnings or usefulness. If the expectation of

earnings of stock rises, the market value of the stock may
rise; at least a part of this increase in price is attributable to

the expectation of increased income.^*

A lump sum substitute for future dividends realized on the sale
of stock may qualify for capital gain rates because a sale of stock
represents a complete transfer of the taxpayer's entire interest in

the property. It is therefore appropriate to regard the lump sum as
a return of capital, not a return on capital. The lump sum in Hort
was not a return of capital because the taxpayer retained his owner-
ship of the building. If, however, the taxpayer had disposed of his

entire interest in the building and leasehold in exchange for a lump
sum partly attributable to future rents to be collected under the
lease, capital gain treatment would undoubtedly have been allowed.

Thus, an amount received in exchange for rights under a lease may
or may not qualify for capital treatment depending on whether the
transaction terminates the taxpayer's interest in the property.

In some cases the lessor rather than the lessee may wish to ter-
minate the lease and may agree to make a lump sum payment. The
receipt of such a payment by the lessee does not usually raise a
substitution for income question because the leasehold interest will

not normally be a direct source of ordinary income to the lessee.

From the perspective of the lessee, the leasehold is beyond the
scope of the Hort rule and is recognized as property for tax pur-
poses." The leasehold may be a capital asset under section 1221 if
not used in a trade or business or a section 1231 asset if used in a

trade or business.^® In either case the transaction normally qualifies

change for a reduction in rent. See Oliver v. Commissioner, 364 F.2d 575, 579-80 (8th

Cir. 1966) (citing Hort v. Commissioner).

'•^United States v. Dresser Indus., Inc., 324 F.2d 56, 59 (5th Cir. 1963).

''Commissioner v. Golonsky, 200 F.2d 72, 73-74 (3rd Cir. 1952).

''See Rev. Rul. 72-85, 1972-1 C.B. 234.



468 INDIANA LAW REVIEW [Vol. 13:463

for capital gain treatment. ^^ Capital gain treatment has also been

upheld when the lessee received money in exchange for releasing
the lessor from a restrictive covenant.^"

Lessees have had greater difficulty getting capital gain treat-

ment in connection with subleases. A cancellation payment from the
sublessee to the lessee-sublessor is usually taxed as ordinary income

under the substitution doctrine of Hort because the sublease was a
source of ordinary income.^^

To the contrary is Miller v. Commissioner.^^ In Miller the tax-
payer held a lease and paid rent of $1,650 per month. The property
was subleased at a monthly rental of $1,885. Two years after the
sublease was entered into, it was cancelled and the headlease assigned
to the sublessee for a single payment of $32,000. The $32,000
presumably represented the present value of the difference between

$1,885 monthly rental on the sublease and $1,650 monthly rental on

the headlease which would have been taxed as ordinary income to

the taxpayer had he continued to hold the lease and the sublease. In

rejecting the Commissioner's argument that the $32,000 was subject
to tax at ordinary rates under the substitution doctrine, the Tax
Court distinguished Hort on the ground that the taxpayer in Miller

completely terminated his interest in the property upon receipt of

the payment, whereas in Hort the taxpayer continued to own the
property in fee simple. The court stated:

By assignment [of his leasehold interest] petitioner disposed
of his entire interest in the property and the fact that the

sublessee provided the consideration therefor and entered

into an agreement to cancel the sublease does not alter the

inescapable conclusion that a sale of income-producing prop-

erty occurred. . . .

. . . Had there been merely a cancellation of the sublease
without the assignment, petitioner would have retained his

"At one time the Commissioner unsuccessfully urged that capital gain treatment

should be denied for lack of a sale or exchange. Commissioner v. McCue Bros. & Drum-
mond, Inc.. 210 F.2d 752 (2d Cir. 1954); Commissioner v. Golonsky, 200 F.2d 72 (3d Cir.

1952). The matter was settled in 1954 with enactment of I.R.C. § 1241 which provides

that amounts received by a lessee for cancellation of a lease shall be considered as

amounts received in exchange for such lease. Internal Revenue Code of 1954, Pub. L.

No. 591, § 1241, 68A Stat. 333.

«llay V. Commissioner, 210 F.2d 390 (5th Cir. 1954), aff'g 18 T.C. 438 (1952)

(distinguishing the lump sum payment in Hort as payment of anticipated rent).

"Rev. Rul. 129, 1953-2 C.B. 97.

"48 T.C. 649 (1967). See also Metropolitan Bldg. Co. v. Commissioner, 282 F.2d

592 (9th Cir. 1960).



1980] CAPITAL GAIN 469

leasehold interest in the property and realized ordinary in-

come in the form of liquidated rental payments.^^

In a 1972 Revenue Ruling, the Internal Revenue Service (IRS)
permitted capital treatment for gain or loss realized by a lessee on

the transfer of his entire leasehold interest to a third party .^^ Prior

to transfer of the leasehold, the lessee had improved and subleased

the leased property. The ruling does not suggest that the lessee's
gain might be regarded as a substitute for ordinary income on the

sublease, presumably because, as in Miller, the lessee disposed of

his entire interest in the leasehold.

Generally, if one is realizing ordinary income directly from a
lease, either as lessor or lessee-sublessor, any disposition of the
leasehold interest which is less than a complete disposition of the

transferor's entire interest in the leasehold as well as the underly-

ing property will give rise to ordinary income under the substitution

doctrine.^^ A complete disposition will avoid the doctrine.^* The ter-
mination of interest limitation on the substitution doctrine of Hort is
necessary because the application of Hort pervasively to all amounts
which represent substitutes for ordinary income would vitiate the
capital gain provisions, at least so far as income-producing property

is concerned. Thus, it is reasonable to assume that the term "proper-
ty" as used in the capital gain provisions includes property which is

productive of ordinary income, but it does not include a limited

income-producing interest carved out of a larger interest owned by
the taxpayer.

'H8 T.C. at 653-54 (emphasis added). Cf. Voloudakis v. Commissioner, 274 F.2d

209 (9th Cir. 1960) (payments to lessee-sublessor who had a reversionary interest in the
lease held ordinary income).

^'^Rev. Rul. 72-85, 1972-1 C.B. 234.

^Tayments received by lessors for damage to leased property are not, of course,

substitutes for rent. Ordinarily, such payments qualify for capital gain treatment

without regard to the termination of interest rule. See Sirbo Holdings, Inc. v. Commis-

sioner, 509 F.2d 1220 (2d Cir. 1975) (compensation by lessee for certain fixtures belong-

ing to lessor should be treated as received in exchange for the fixtures); Boston Fish

Market Corp. v. Commissioner, 57 T.C. 884 (1972) (cash payment received by lessor in

settlement of lessee's obligation to restore leasehold to original condition held taxable

as capital gain to the extent it exceeded the cost of the restoration); Hamilton Main,

Inc. V. Commissioner, 25 T.C. 878 (1956) (compensation for damage to leased building a

return of capital and applied to reduce the lessor's basis). Cf. Raytheon Prod. Corp. v.

Commissioner, 144 F.2d 110 (1st Cir. 1944) (compensation for injury to goodwill treated

as return of capital).

Compensation for related expenses, however, has been denied capital gain treat-

ment. Sirbo Holdings, Inc. v. Commissioner, 509 F.2d 1220 (2d Cir. 1975) (compensation

for expense of removing debris abandoned by lessee held ordinary income).

^Compare Rev. Rul. 129, 1953-2 C.B. 97, with Rev. Rul. 72-85, 1972-1 C.B. 234.



470 INDIANA LA W REVIEW [Vol. 13:463

B. Assignment of Income Doctrine

Although the Supreme Court has not ruled on the question of
whether leaseholds can be gratutiously assigned for income tax pur-

poses, the IRS and several circuit courts have considered the issue.
The IRS apparently applies the same standard for assignment of

income purposes as the courts have applied for capital gain pur-

poses. For the assignment to be effective for income tax purposes, it

must be a transfer of the taxpayer's complete interest in the proper-
ty, not a limited interest carved out of a larger estate. Revenue Rul-
ing 58-337" involved the transfer of a leasehold interest by the fee
owners to a ten-year trust for the benefit of the grantors' children.
In ruling that the grantors would continue to be taxed on the rental

income the Service stated:

Prior to the creation of the trust in the instant case, the

fee owners had carved out of their ownership two separate
estates, a leasehold and a reversion. The leasehold was then
made the subject of the trust here involved. When a fee
owner/lessor assigns a lease without assigning the reversion,

only the right to the rent passes to the assignee. According-

ly, the assignment of the lease in trust without an attendant

assignment of the reversion constitutes an assignment of in-

come for which the grantor remains taxable, since he may
not escape the tax on his income by giving it away or assign-
ing the right to receive it in advance of payment.^28

The Service buttressed its argument by noting that the
leasehold itself was not transferred absolutely because the trustee
was prohibited by the trust instrument from reassigning the
leasehold. It is doubtful, however, that the restriction on reassign-

ment was crucial to the holding.
In Iber v. United States,^ the taxpayer owned real estate sub-

ject to a lease and transferred the lease to a ten-year trust.^° The
government argued that "an assignment of a lease by one who con-
tinues to hold the reversionary interest in the land never con-

stitutes a transfer of income-producing property."^^ The Court of Ap-
peals for the Seventh Circuit declined to adopt so broad a rule,

"1958-2 C.B. 13.

""Id. at 13.

^409 F.2d 1273 (7th Cir. 1969).

'"Under the grantor trust rules of I.R.C. §§ 671-677, one may transfer income pro-

ducing property to a trust for 10 years or more and have the income distributed and

taxed to another person during the life of the trust. These rules represent a statutory

exception to the assignment of income doctrine.

="409 F.2d at 1275.



1980] CAPITAL GAIN 471

holding instead that the transfer was ineffective because the
assignor retained a reversionary interest in the leasehold.^^ Never-

theless, the opinion focuses upon the fact that title to the income-

producing property remained with the assignor and that deductions

for depreciation and real estate taxes had been claimed by the

assignor after he had assigned the lease.^^ The implication is clear
that the assignor would have been taxed on the rental income even

if he had transferred the entire leasehold retaining a reversion only

in the underlying property. Otherwise, the income interest could be

separated and assigned while deductions attributable to the produc-

tion of the income were claimed by the taxpayer.

Contrary to the implication of Iber that a leasehold can never be

effectively assigned by the fee owner is Lum v. Commissioner.^^ In
Lum the owner-lessor assigned by gift all of his rights as landlord,
retaining no interest whatever in the leasehold. Although the

assignor took deductions for real estate taxes, maintenance expense,

and depreciation on the leased property, the Third Circuit Court of

Appeals concluded that the assignment constituted a transfer of

income-producing property. Rental income was held taxable to the
assignee.^^

In ruling upon a set of facts similar to those of Lum, the Fourth
Circuit rejected the taxpayer's contention that more than a right to
income was assigned, noting that "[t]he taxpayer does not suggest
what these additional rights were and we have been unable to
discover them."^® During the term of the lease the taxpayer claimed

deductions for taxes, maintenance expense, and depreciation. The
court found these deductions indicative of an intent to retain owner-

ship of the reversion and to transfer to the donee only the leasehold,

which consisted of little more than a right to rent.^^ Although the
assignee received a property interest under state law, the court

characterized it as a nonassignable income interest for purposes of

federal taxation.^®

The Seventh and Fourth Circuits hold that the gratuitous
assignment of a leasehold by one who owns the underlying property
will be ineffective to shift the incidence of tax on the rent. This con-

clusion is consistent with the treatment of leaseholds under the

capital gain provisions in which sale of the leasehold by the owner of

''Id.

""Id. at 1276.

''*147 F.2d 356 (3d Cir. 1945).

^/d. at 357.

'"United States v. Shafto, 246 F.2d 338, 342 (4th Cir. 1957).

'Ud. at 343.

""Id.



472 INDIANA LAW REVIEW [Vol. 13:463

the underlying property is treated as sale of an income interest giv-

ing rise to ordinary income rather than capital gain.

The Third Circuit's treatment of the assignment of a leasehold
by one who owns the underlying property as the assignment of a
property interest effective for tax purposes is inconsistent with the

capital gain cases and with the fundamental principle that income

derived from property is taxed to the owner of the property. In an
economic sense, only the physical property itself is productive of in-

come. The leasehold is nothing more than a legal arrangement
entered into by the owner of the property for exploitation of its
economic value. As the Third Circuit recognized, there is merely a
technical distinction between assignment of a leasehold and assign-

ment of a right to collect rent.^^ That distinction fails to justify
recognition, for income tax purposes, of the assignment of a

leasehold but not the assignment of a mere right to collect rents.*"
If the leasehold is assigned along with ownership of the underly-

ing property, rent accruing after the date of assignment is taxable

to the assignee as owner of the property. In the case of a transfer to

a ten-year trust, rent is taxable to the assignee even though the

assignor does not make a complete transfer of his entire interest in
either the leasehold or the underlying property. For example, if, as

in the Iber case, a taxpayer owns real estate subject to an eleven-
year lease, the rental income can be assigned by transferring title to

the underlying property as well as the leasehold to a properly

qualified ten-year trust. The trustee is entitled to deductions for
real estate taxes, maintenance expense, and depreciation during the

term of the trust, and it is appropriate for the income to be taxed to

the trustee or to the trust beneficiaries under the normal rules of

trust taxation.

Although there are no cases directly on point, a lessee should be

able to assign a leasehold interest by gift if he assigns his entire in-

terest in the leasehold and has no interest in the underlying proper-

ty. In the Miller case the taxpayer-lessee who was obligated to pay
rent of $1,650 per month subleased the property for $1,885 per

month. The leasehold itself was a valuable income-producing interest
which was sold for $32,000. The Tax Court characterized the trans-

action as a sale of property qualifying for capital gain treatment. By

^The court characterized the distinction as "technical but real," "real" in the
sense that if rent were asigned, "the landlord retained his interest and made a gift of
the rent," whereas if the leasehold were assigned, "he transferred his interest as
landlord." Lum v. Commissioner, 147 F.2d at 357. The court's analysis lacks substance.

*°The courts are unanimous in holding the gratuitous assignment of a right to

rent ineffective for tax purposes. Gait v. Commissioner, 216 F.2d 41 (7th Cir. 1954);

Ward V. Commissioner, 58 F.2d 757 (9th Cir. 1932); Bing v. Bowers, 22 F.2d 450
(S.D.N.Y. 1927).



1980] CAPITAL GAIN 473

analogy, a gratuitous transfer of the leasehold would qualify as a

transfer of income-producing property effective for tax purposes.

III. Life Estates

A. Assignment of Income Doctrine

In Blair v. Commissioner,"^^ the owner of a life estate in a

testamentary trust gave to his daughter an income interest amount-

ing to $9,000 per year for the duration of the life estate. The income

versus property issue was particularly acute. If, in accordance with

economic reality, the life estate were treated as a nonassignable in-

come interest for tax purposes, the taxpayer could never assign the

income even if he were to make a complete gift of his entire life
estate because he would be powerless to assign the underlying prop-

erty. On the other hand, if the life estate were unqualifiedly recog-
nized as income-producing property, nothing would prevent the tax-

payer from assigning any portion of it he chose. He could assign or
keep the income on a year-by-year basis.

The Supreme Court observed that the taxpayer did not attempt
to "limit the assignment so as to make it anything less than a com-
plete transfer of the specified interest" assigned.^^ Because there

was a complete transfer of a vertical slice of the life estate, the

Court held the assignment effective for income tax purposes.^^

In Harrison v. Schaffner,*^ the life beneficiary of a trust assigned

to her children income from the trust for a one-year period. Unlike

Blair, Harrison did not involve a complete transfer of a specified in-

terest. In holding the transfer ineffective for tax purposes, the Har-

rison Court stated:

We think that the gift by a beneficiary of a trust of some
part of the income derived from the trust property for the

period of a day, a month or a year involves no such substan-
tial disposition of the trust property as to camouflage the

reality that he is enjoying the benefit of the income from the

trust of which he continues to be the beneficiary. . . . Even
though the gift of income be in form accomplished by the

temporary disposition of the donor's property which pro-

duces the income, the donor retaining every other substan-

tial interest in it, we have not allowed the form to obscure
the reality.'*^

"300 U.S. 5 (1937).

«/d. at 13.

"/d. at 14.

"312 U.S. 579 (1941).

*'Id. at 582-83.



474 INDIANA LA W REVIEW [Vol. 13:463

Blair clarified that the complete transfer of a life estate would
be recognized as a transfer of income-producing property for tax
purposes. Harrison obscured the issue by holding that an interest in
a life estate limited to one year, which is a thin horizontal slice of
the life estate, would not be recognized because the taxpayer did
not make a "substantial disposition of the trust property."** What
would qualify as a substantial disposition was not addressed by the
Court.

In 1955 the IRS ruled that a gratuitous, irrevocable assignment
of a life estate for a period of not less than ten years would be
recognized for tax purposes and the income would be taxable to the
assignee.*^ The ruling was a pragmatic one in view of the fact that a
life estate, transferable in its entirety under Blair, could be effec-
tively transferred by gift for a ten-year period under sections
671-677 of the IRC. The economic effect of transferring a life estate
to a ten-year trust with income payable to a donee-beneficiary would
be identical with a direct transfer to the donee of a ten-year interest
in the life estate. Thus, the IRS position is reasonable in view of the
statutory provisions.

B. Capital Gain Versus Ordinary Income

In McAllister v. Commissioner,*^ the taxpayer transferred her

entire life interest in a trust to the remainderman for $55,000. Rely-
ing on Hort, the Commissioner argued that the $55,000 was received

as consideration for a right to income which would have been taxed

at ordinary rates if distributed as earned, and that the $55,000

should therefore be taxed at ordinary rates under the substitution

for income doctrine. The Court of Appeals for the Second Circuit
relied upon the decision in Blair that the gratuitous transfer of an

income interest in a trust was the assignment of a property right

with subsequent income, taxable to the donee," and held the transac-

tion to be a disposition of property taxable at capital gain rates.^"

The court had some difficulty in distinguishing the Hort case:

Here the line of demarcation between the Blair and Hort

principles is obviously one of some difficulty to define ex-
plicitly or to establish in borderline cases. Doubtless all

*7d. at 582.

*^Rev. Rul. 55-38, 1955-1 C.B. 389.

"157 F.2d 235 (2d Cir. 1946).

*Vd. at 236.

""Id.



1980] CAPITAL GAIN 475

would agree that there is some distinction between selling a
life estate in property and anticipating income for a few

years in advance. . . . The distinction seems logically and

practically to turn upon anticipation of income payments

over a reasonably short period of time and an out-and-out

transfer of a substantial and durable property interest, such

as a life estate at least is.^^

Although McAllister and Hort both involved a gain on a sale,

the McAllister court distinguished Hort and relied upon Blair which

involved a gift. Was it simply that McAllister and Blair each involved
disposition of a substantial and durable property interest, whereas

Hort did not? Although the court's language supports this conclu-

sion, it provides no explanation as to why the fifteen-year leasehold
in Hort with nine years remaining and annual rent of $25,000 was
not a substantial and durable property interest.

The court probably characterized the life estate in McAllister as
a property interest because the taxpayer had assigned his entire in-

terest in the property, whereas in Hort the taxpayer-lessor merely

terminated a lease and continued to hold the property as a fee

owner. McAllister and Hort can be reconciled only if termination of
interest rather than durability is regarded as the appropriate test

for determining the property versus income issue. Admittedly there

is no direct support for the termination of interest analysis in the

McAllister case. Nevertheless, termination of the transferor's in-

terest was the only sound reason for the Supreme Court's holding in
Blair that property rather than income was transferred. McAllister
relied upon Blair and thus presumably upon a termination of in-

terest theory.

Most life estates are acquired either by gift or bequest. The
basis determined under sections 1014 or 1023 in the case of a be-

quest, or section 1015 in the case of a gift, cannot be amortized.^^ At
the time of the McAllister decision, however, the basis could be

used to reduce gain on a sale, thus providing a great incentive for

sale. Congress subsequently modified the effect of McAllister with

section 1001(e) which provides that upon sale of a life estate any basis

determined under sections 1014, 1023, or 1015 shall be disregarded.^^

Thereafter, the IRS announced that it will follow the holding of

"/d. at 235, 237 (emphasis added).

"I.R.C. § 273.

'nn 1976 when § 1023 was adopted, Tax Reform Act of 1976, Pub. L. No. 94-455,

90 Stat. 182-77, § 1001(e) was not amended to apply to bases determined under § 1023.

However, § 1001(e) was so amended in 1978. Revenue Act of 1978, Pub. L. No. 95-600,

92 Stat. 2928.



476 INDIANA LAW REVIEW [Vol. 13:463

McAllister with respect to a sale by a life beneficiary of his entire

interest.^^

IV. Oil, Gas, and Mineral Interests

A. Capital Gain Versus Ordinary Income

Under the rule of Hort, one who owns real estate may not sell a
leasehold and retain the underlying property for purposes of the

capital gain provisions. The proceeds of such a "sale" are taxed as
rental income. If one owns real estate upon which a natural deposit
exists, however, he is regarded as holding two separate assets: the
real estate and the deposit. The deposit may be sold in place for a
fixed consideration and the gain taxed at capital rates.^^ The seller,
having sold the depletable asset, will not be entitled to deductions

allowed for depletion.^^ No substitution for income issue will arise by
virtue of the seller's retention of the underlying real estate.

On the other hand, if the owner engages in the busines of ex-
ploiting the deposit he will qualify for the depletion allowance, but

resulting income will be taxed at ordinary rates because no sale or

exchange is involved." He may also engage in exploitation indirectly
by entering into a lease or contract whereby others will carry on ex-
ploitation activities. In the latter case, it may be unclear whether
the owner has sold the natural deposit in place with gain taxed at
capital rates,^^ or has arranged for exploitation of the deposit with

income subject to depletion and taxed at ordinary rates.

The touchstone which emerges from several oil and gas cases
decided by the Supreme Court is whether the owner has retained an
economic interest in the deposit.^® If an economic interest has been

retained, no sale has occurred and income is taxed at ordinary rates

subject to depletion. If no economic interest has been retained — the
deposit has been sold in place, payments received by the seller may
qualify for capital gain treatment, but the seller will not be entitled

to any depletion allowance. Most of the Supreme Court decisions in-
volved taxpayers who had assigned exploitation rights to a natural

"Rev. Rul. 72-243. 1972-1 C.B. 233.

^^Whitehead v. United States, 555 F.2d 1290 (5th Cir. 1970). See Treas. Reg.

§ 1.221-1.

""See Treas. Reg. § 1.611-l(b).

"See id.

''See, e.g.. Cox v. United States, 497 F.2d 348 (4th Cir. 1974); United States v.

White, 401 F.2d 610 (10th Cir. 1968); Commissioner v. Remer, 260 F.2d 337 (8th Cir.

1958).

'"E.g., Commissioner v. Bankline Oil Co., 303 U.S. 362 (1938); Thomas v. Perkins,

301 U.S. 655 (1937); Palmer v. Bender, 287 U.S. 551 (1933). See 4 J. Mertens. Law of
Federal Income Taxation § 24.21 (1977).

i



1980] CAPITAL GAIN 477

deposit in exchange for some form of periodic payment. Typically,
the taxpayer-assignor attempted to treat the transaction as an ex-

ploitation arrangement producing ordinary income, with attendant

depletion allowances, rather than as a sale.^° The Commissioner urged

that the taxpayer had sold his economic interest in the oil or gas

deposit and thus had nothing to deplete.®^

Although most of the cases in which the economic interest test

was developed involved the availability of deductions for depletion

rather than the availability of capital gain treatment, the deter-

minative question for both purposes is the same: whether a sale oc-

curred. Thus, the economic interest test applies to the determina-

tion of whether a transaction involves a sale of a natural deposit or

an exploitation contract.^^ Several Supreme Court decisions provide
a foundation for the economic interest test. These decisions merit

careful evaluation.

Although the Court in these cases focused on whether a sale had

occurred, the economic interest test which it applied is identical in

substance to the test applied in Hort for the purpose of determining

whether a property interest or an income interest had been sold. Here,

just as under Hort, a retained interest will negate capital gain treat-

ment. The only difference is a superficial one in that here a retained in-
terest breaches the sale or exchange requirement, whereas under
Hort it breaches the property requirement.*^

In considering the cases, it is important to keep in mind the
distinction between two forms of payment commonly used in oil, gas,
and mineral transactions. One who owns a natural deposit in place is
said to hold the "working interest" because he has the power of ex-
ploitation. He may transfer the working interest to another in ex-
change for a royalty which entitles him to a specified percentage of

production without limitations on the total amount which may be

^°But see text accompanying note 69 infra for a discussion of Burton-Sutton Oil

Co. V. Commissioner, 328 U.S. 25 (1946), which applied the economic interest test for a

purpose other than determining the availability of depletion deductions.

''See Kirby Petroleum Co. v. Commissioner, 326 U.S. 599 (1945); Palmer v.

Bender, 287 U.S. 551 (1933). Both cases are discussed in the text accompanying notes

64-68 infra.

"'Vest V. Commissioner, 481 F.2d 238 (5th Cir. 1973). "[I]t has also been recognized

on several occasions that regardless of the original purpose of the economic interest

test, it is substantially the same as the test employed to determine whether income is

taxable as capital gain or ordinary income." Id. at 242. But see Barker v. Commis-

sioner, 250 F.2d 195 (2d Cir. 1957).

*^his parity of treatment is entirely appropriate. In applying the capital gain

provisions, uniform standards should be applied irrespective of the subject matter of

the transaction. If a retained interest disqualifies a transaction involving a leasehold or

a life estate, it should also disqualify a transaction involving a natural deposit or a

franchise.



478 INDIANA LAW REVIEW [Vol. 13:463

received. As an alternative, he may receive only a "production pay-
ment" entitling him to a specified percentage of production up to a
specific dollar amount. In short, the production payment is like a
royalty except that it provides for a maximum amount payable. The
distinction between a royalty and a production payment has been a
significant factor in applying the economic interest test.

1. Cases Involving Royalties or Other Unlimited Payments.—
Palmer v. Bender,^* the first Supreme Court decision applying the
economic interest test, concerned taxpayers who had acquired,
through a lease, complete control of an oil deposit. Although referred

to as lessees, the taxpayers clearly owned the deposit in place and
were free to sell it outright for a lump sum or to exploit it them-
selves. Instead, the taxpayers assigned the exploitation rights to an

oil company in exchange for (1) an immediate cash payment, (2) a de-
ferred payment of $1,000,000 to be paid out of one-half of the first oil
produced, and (3) a royalty of one-eighth of all oil produced. The
Commissioner urged that inasmuch as taxpayers transferred all of

their rights in the deposit, the transaction was a sale rather than a
sublease under applicable state law and that the taxpayers were not
entitled to depletion deductions. Noting that whether the transac-

tion was a sale or a sublease under state law is immaterial for
federal tax purposes, the Supreme Court held that the taxpayers
"retained, by their stipulations for royalties, an economic interest in

the oil in place identical with that of a lessor."®^ Through the royalty
agreement, the taxpayers shared in the oil produced and in the risk

of the oil being destroyed. Since the taxpayers retained an economic

interest, they were entitled to an equitable portion of the depletion

allowance.®* It was thus established that a retained royalty based on

output or production is a retained economic interest.

In Kirby Petroleum Co. v. Commissioner,^'' the owner in fee of
the real estate leased it for the production of oil, gas, and other

minerals. The lessee agreed to pay the taxpayer a lump sum bonus,
a royalty based on production, and twenty percent of the net profits

realized from exploitation under the lease. The Commissioner al-
lowed depletion deductions based on royalty payments and the

bonus, which was regarded as an advance royalty, but denied deple-

tion based on income derived from the profit sharing arrangement.

In overruling the Commissioner, the Court stated:

""287 U.S. 551 (1932).

''Id. at 558.

""When more than one party has an economic interest in a depletable asset, the

depletion allowance must be equitably apportioned. I.R.C. § 611(b).
"^326 U.S. 599 (1946).



1980] CAPITAL GAIN 479

If the additional payments in these leases had been a
portion of the gross receipts from the sale of oil extracted

by the lessees instead of a portion of the net profits, there

would have been no doubt as to the economic interest of the
lessors in such oil. This would be an oil royalty. The lessors'
economic interest in the oil is no less when their right is to a
share of net profit.^®

Burton-Sutton Oil Co. v. Commissioner^^ involved a similar trans-

action wherein the taxpayer, an oil company engaged in exploitation
activities, had obtained an oil lease by assignment, and agreed to pay

the lessee-assignor fifty percent of the net profit realized from produc-

tion. The taxpayer deducted these payments on the theory that the
lessee-assignor retained an economic interest in the deposit and that

the payments were similar to rent on a sublease. The Commissioner

denied the deduction, claiming that the lessee-assignor had sold its en-

tire interest and the payments were nondeductible acquisition costs.

The government attempted to distinguish Kirby wherein the
taxpayer had retained a right to royalties based on production as

well as a right to share in net profits. The Court responded:

We do not agree with the Government that ownership of
a royalty or other economic interest in addition to the right

to net profits is essential to make the possessor of a right to
share in net profits the owner of an economic interest in the
oil in place. The decision in Kirby did not rest on that
point.'"

The Court observed that one could divest himself of his economic
interest as by a sale for cash, but that no such divestment occurs

where one retains an interest in net profits. Because the lessee-
assignor had retained an economic interest through the profit shar-

ing arrangement, the taxpayer had not purchased the lease and was
entitled to deduct profit sharing payments. Burton-Sutton clarifies

that the owner of a deposit who assigns the working interest in ex-
change for a right to share in net profits has retained an economic

interest.'^

In Commissioner v. Southwest Exploration Co.,''^ the taxpayer

«7d. at 604.

«»328 U.S. 25 (1946).

'''Id. at 32.

"M at 36. Cf. Commissioner v. Elbe Oil Land Dev. Co., 303 U.S. 372 (1938) (holding
that a profit sharing arrangement did not constitute a retained economic interest in the
transferor was limited to its facts).

''350 U.S. 308 (1956).



480 INDIANA LAW REVIEW [Vol. 13:463

owned real estate which was upland from oil deposits off the coast
of California but held no interest in the oil deposits themselves.

Under state law the offshore oil could be recovered only by slant
drilling from the uplands. The taxpayer entered into an agreement
with Southwest Exploration whereby Southwest would recover the
offshore oil through drilling operations conducted on taxpayer's prop-

erty. The taxpayer received a percentage of the net profits and took
a deduction for depletion.

In determining whether the taxpayer was entitled to depletion,
the Court noted that to qualify for the deduction one must have ac-
quired an interest in the oil in place. Although the taxpayer had no

direct ownership interest in the offshore oil, use of the uplands was
essential to exploitation and the Court thus held that the taxpayer

had an economic interest in the oil in place.^^ The economic interest
consisted of control over exploitation which could have been sold to

Southwest for a stated sum of money. Instead, the taxpayer retained
an economic interest by permitting use of the uplands for a share of

the profits. Income derived therefrom was ordinary income subject
to depletion.

Under these Supreme Court decisions, the owner of a natural
deposit who has arranged for exploitation in a manner which makes
his return dependent upon royalties, net profits, or other measures

of production has retained an economic interest in the deposit.^*

Although the decisions did not deal directly with the capital gain

versus ordinary income issue, it is apparent that one who has retained
an economic interest has not terminated his interest in the deposit;

thus, the rule of Hort denies capital gain treatment. Although the

lower courts have accepted this proposition,^^ they have had difficul-

ty applying the economic interest test.

According to the Eighth Circuit's decision in Commissioner v.

Remer,''^ making payment of the purchase price a function of produc-

'Ud. at 316.

^*For one to retain an economic interest in connection with an exploitation trans-

action, it is necessary that he hold such an interest before the transaction. One who

owns the deposit in place, that is, holds the exploitation rights and is entitled to all in-

come therefrom, clearly holds an economic interest. Since our concern is with how such

a taxpayer's exploitation transaction will be characterized, the issue of whether more

limited interests may also qualify as economic interests will not be discussed. Compare
Southwest Exploration Co. (fee owner of land adjoining that on which deposit existed

who, by virtue of such proximity to the deposit, controlled production had an economic

interest in the deposit), with Paragon Jewel Coal Co. v. Commissioner, 380 U.S. 624

(1965) (mine operator's contract right to mine coal for sale to mine owner at a certain

price did not give operator an economic interest in the coal in place). See generally 4

J. Mertens, supra note 59, § 24:21, at 83-87.

''^See note 62 supra.

'•'260 F.2d 337 (8th Cir. 1958).



1980] CAPITAL GAIN 481

tion will not in itself cause an economic interest to be retained by

the transferor. In Renter the taxpayer transferred mineral leases in

exchange for lump sum payments plus ten cents per ton of mineral
extracted by the transferee. In upholding capital gain treatment the

court stated:

The written assignments were in the language of an absolute

sale under warranty of title and contained no provision re-

taining any interest in the property so sold. The provision in

the assignments for the payment of ten cents per ton on

such concentrates as might be shipped imposed no obligation

on the transferee to ship any ore, and the transferor retained

no interest in the ore in place. The consideration to be paid
was definite and absolute and the provision with reference

to paying ten cents per ton for the ore shipped was simply a
method of measuring the added consideration to be paid. The
transferor had the bare right to payments measured by pro-

duction. This did not, we think, result in the transferor re-
taining an economic interest in the property sold.^^

In Rahiner v. Bacon,^^ the Eighth Circuit declined to apply the

rule of Renter to a fee owner of gravel land who was to receive a
fixed price per ton of gravel removed. The court stated:

[T]axpayer's income here was derived solely from the extrac-
tion of the mineral and was geared to the production of the
mineral. We think it can be safely said that taxpayer retained
an economic interest in the subject minerals whether any

were mined or not. He had an economic interest in the
minerals mined by reason of income he received from the ex-
ploitation of his lands and the extraction of the minerals.^^

Because the taxpayer had an economic interest in the gravel in

place, capital gain treatment was denied. The Renter case was
distinguished as involving the assignment of a mineral lease by a

lessee rather than the granting of a mineral lease by a fee holder.®"

This distinction is without merit because a fee holder may make an
effective sale of the mineral deposit in place for tax purposes, pro-

vided only that he has not retained an economic interest in the

deposit.®^

The Tenth Circuit reached a result contrary to Renter in United

'Ud. at 339. See also Lineham v. Commissioner, 297 F.2d 276 (1st Cir. 1961).
^«373 F.2d 537 (8th Cir. 1967).

''Id. at 539.

'°Id.

*'See notes 55-58 supra and accompanying text.



482 INDIANA LA W REVIEW [Vol. 13:463

States V. White, ^"^ a case involving very similar facts. In White y the

taxpayer transferred uranium land by an outrigtt mineral deed, re-
taining no reversionary interest. In exchange, he received a lump
sum payment of $175,000 plus ten percent of the gross value of all
minerals mined. The taxpayer retained no control over exploitation;
the transferee could recover the minerals or not, as he wished. In

the first consideration of the case,®^ the Tenth Circuit held that the

taxpayer "retained no investment or interest, economic or other-

wise, in the minerals in place"^^ and was entitled to capital gain
treatment on the lump sum. The court specifically declined to deter-
mine the character of the percentage payments.®^

Six years later, the court considered the same transaction for
characterization of the percentage payments.** Noting that a single

disposition of the mineral rights necessitated a single characteriza-

tion of the consideration received, the court overruled its earlier

decision and concluded that the taxpayer had retained an economic

interest and that all amounts realized were properly characterized

as ordinary income.®^

The court in White noted that the Remer decision was based
upon an agreement to pay a fixed amount per unit, whereas the tax-
payer in White was to receive a percentage of the value of the
recovered ore. As the court implied, the distinction is specious®*
because in both cases the taxpayer's return is dependent upon pro-

duction. The added variable of the recovered ore's value should be
immaterial.*^

2. Cases Involving Production Payments or Other Limited
Payments.— The Supreme Court has had some difficulty applying
the economic interest test to production payments. A production
payment entitles the holder to a specified sum of money payable

«'401 F.2d 610 (lOth Cir. 1968).

^'United States v. White, 311 F.2d 399 (10th Cir. 19Q2), overruled, 401 F.2d 610 (10th

Cir. 1968).

^"311 F.2d at 402.

''Id. at 403.

«M01 F.2d 610 (10th Cir. 1968).

'Ud. at 614. At least one court has suggested that a retained interest of insignifi-

cant value ought not to characterize the entire transaction. Wood v. United States, 377
F.2d 300 (5th Cir. 1967).

'"Id. at 612. See Cox v. United States, 497 F.2d 348 (4th Cir. 1974) (lessee who

assigned oil and gas leases for a lump sum payment plus a percentage of production

had ordinary income); Commissioner v. Pickard, 401 F.2d 615 (10th Cir. 1969); Wood v.
United States, 377 F.2d 300 (5th Cir. 1967). "Under the economic interest test, the

critical consideration is whether payment is dependent upon extraction, not the

method by which that payment is calculated." Id. at 306.
«''401 F.2d at 612.



1980] CAPITAL GAIN 483

from production. Unlike a royalty, it contemplates a limited rather

than an unlimited return. Should such a limited return be con-

sidered dependent on production and therefore an economic in-

terest? At first blush, it would clearly seem so. If one transfers the
working interest in an oil deposit to another in exchange for

$395,000 to be paid at the rate of twenty-five percent of the oil pro-

duced, his return is dependent on production because no return will

be realized unless oil is produced. In Thomas v. Perkins,^^ the
Supreme Court held under similar circumstances that the transferor
did not sell the oil in place for $395,000 payable from production, but

instead arranged for exploitation while retaining ownership. Thus,

the transferor was taxed at ordinary rates on the twenty-five per-
cent portion of the income from production used to satisfy the

$395,000 obligation.'^

It could be argued, however, that a retained production payment
should not be regarded as an economic interest. The economic in-
terest test appropriately looks to the risk of ownership to determine

whether an interest has been sold.'^ If the transferor continues to

bear the risk of ownership, he has not sold his interest. If the

transferor is entitled to a specified sum regardless of production, he
has shifted the risk of ownership to the transferee. Risk is a double-

faceted concept, involving the possibility of gain as well as loss. The
transferor in Perkins relinquished the possibility of gain beyond

$395,000, but the fact that he continued to bear the risk of loss was
apparently deemed sufficient to negate a sale.

Three years later, in Anderson v. Commissioner,^^ the Court
sharply curtailed the rule of Perkins. In Anderson, oil properties, in-

cluding fee interests, were transferred in exchange for a specified

sum of money payable from oil or gas to be produced and from pro-
ceeds realized upon a resale of the fee interests in any of the prop-

erties conveyed. Payments due under the agreement were secured
by liens on the oil and gas produced and on the fee interests. The
Court distinguished Perkins on the basis that it involved only a

reservation by the transferor of an interest in production, whereas

in Anderson there was reserved an interest in the fee and in produc-
tion. "In the interests of a workable rule," the Court observed,

''Thomas v. Perkins must not be extended beyond the situation in

»°301 U.S. 655 (1937).

»7d. at 661.

"'See Palmer v. Bender, 287 U.S. 551, 558 (1933). In Palmer, the taxpayers

possessed an economic interest through a royalty contract, which allowed them to

share in the income from the oil produced as well as the loss resulting from the

destruction of oil in place. See id. at 558.
•''310 U.S. 404 (1940).



484 INDIANA LAW REVIEW [Vol. 13:463

which . . . the reserved payments are to be derived solely from the
production of oil and gas."^^

After Perkins and Anderson, a retained production payment
payable solely from production will be treated the same as a re-
tained royalty and will constitute an economic interest negating a

sale; if the production payment is secured by anything other than
production it will not be regarded as an economic interest. This

technical distinction, which is without practical significance in many
instances, probably resulted from the Court's recognition in Ander-

son that Perkins was wrongly decided and a reluctance to overrule
Perkins so soon after it had been decided. Nonetheless, these early

Supreme Court decisions mean that establishing a total maximum
price, as and when recovered, will not qualify the transaction for
capital gain treatment.^^ On the other hand, a fixed price which is to
be paid from production if the deposit is exploited but which is due

in any event qualifies for capital gain. It does not result in a retained

economic interest because the purchase price is not dependent upon

production.^^

As a practical matter, collecting the price depends on production
unless there is personal liability on the obligation. Personal liability,

however, has not been regarded as crucial. In Strutzel v. Commis-

sioner,^'' for example, the taxpayer owned mining rights which gave
him power to extract and sell certain mineral deposits. In effect, the
taxpayer owned in place any such deposits discovered on the proper-
ty. He transferred his entire interest for $500,000, payable in fixed
installments over a ten-year period. If the transferee exploited the

deposits, the taxpayer-transferor was entitled to a five percent pro-
duction payment which would reduce the fixed installments and the

$500,000 purchase price. In the event of default, the mining rights

would revert to the taxpayer without further obligation on the part

of the transferee.

In upholding capital gain treatment the Tax Court observed that
"[p]roduction royalties, if paid, would only serve to accelerate pay-

ment of the total purchase price."** The court therefore concluded
that the provision for a reverter in the event of default did not con-

stitute a retained economic interest.** Although the installment

payments were not technically dependent on production because

they were due in any event, as a practical matter they were depen-

dent. If the claims proved worthless, the transferee could simply

'*Id. at 413.

"'United States v. Witte, 306 F.2d 81 (5th Cir. 1962).

'''Strutzel V. Commissioner, 60 T.C. 969 (1973).

''QO T.C. 969 (1973).

«7d. at 974.

""Id. at 976.



1980] CAPITAL GAIN 485

default and allow the claims to revert to the transferor. Note that

capital gain treatment would not have been available if the contract

had called for a five percent production payment not to exceed
$500,000. This premium on drafting is an unfortunate side effect of
the Supreme Court's distinction of Perkins in Anderson. The Court
should have overruled Perkins by holding that establishing a max-

imum price strips the assignor of the principal benefit of ownership,
the possibility of speculative gain, without which there is no reten-

tion of a meaningful economic interest. ^°°

3. Sale of Retained Interest. — A question closely related to
that of characterizing the original exploitation transaction may arise
if the entire retained interest is transferred at a later date. If the

taxpayer disposes of his retained interest and thereafter has no

economic interest in the deposit, transfer of the carved-out interest

originally retained ordinarily qualifies for a capital gain treatment.
^''^

This is true even though the carved-out interest would have been

productive of the ordinary income to the transferor if he had con-

tinued to hold it. Thus, a twelve percent royalty, which yields an

average of $15,000 annually taxable at ordinary rates, could be sold

for a lump sum payment taxable at capital gain rates. The result is
sensible. Because the initial transfer would have qualified for capital

gain treatment if it had terminated the taxpayer's interest, the sec-

ond transfer, which did terminate it, should qualify.

Consistent with this analysis is the Supreme Court's holding in
Commissioner v. Lake^^^ that transfer of a carved-out interest does

not qualify for capital gain treatment if the transferor's interest in

the deposit is not terminated. ^°^ In Lake, a corporate taxpayer which

held oil and gas leases for exploitation transferred to its president

an oil payment right^"* in the amount of $600,000, payable from the
working interest, in exchange for cancellation of a debt. After pay-

ment of the $600,000, the taxpayer would be restored to its original

'""By the same reasoning a bootstrap sale of a business could qualify for capital

gain treatment without violating the principles of the oil, gas, and mineral cases. See

Commissioner v. Brown, 380 U.S. 563 (1965) (sale of stock in a wholly-owned corpora-

tion in exchange for a specified sum to be paid out of post-sale profits held subject to
capital gains tax). Three justices dissented, stating that "the sellers here retained an

economic interest in the business fully as great as that retained by the seller of the oil

interests in Thomas v. Perkins. " Id. at 586 (Goldberg, Black, J.J., & Warren, C.J.,
dissenting).

""Rev. Rul. 73-428, 1973-2 C.B. 303.

'"='356 U.S. 260 (1958).

""Id. at 268.

'"*As described by the Court, an oil payment is "the right to a specified sum of
money, payable out of a specified percentage of oil, or the proceeds received from the

sale of such oil, if, as and when produced." Id. at 261 n.l.



486 INDIANA LA W REVIEW [Vol. 13:463

position with respect to the working interest. In short, the taxpayer

assigned $600,000 of the future income it expected to realize from

the leases.

In holding that ordinary income resulted from the debt cancella-

tion, the Court relied upon its earlier decision in Helvering v.

HorsV^^ that a taxpayer who detached interest coupons from
negotiable bonds and made a gift of them to his son was taxable on
the interest even though it was paid to his son.^"^ The coupons were
characterized as income interests which could not be assigned by

gift.^"^ Similarly, the Lake Court characterized the oil payment right
as an income interest which could not be sold at capital rates,

stating: "Only a fraction of the oil . . . rights were transferred, the
balance being retained."^"® Although much of the opinion in Lake
concerned the type of interest that was transferred, the clear im-
plication was that there could be no capital gain treatment because
the source of the income was retained. Under either rationale a com-
plete termination of interest would qualify the transaction as a

transfer of property for capital gain purposes.

B. Assignment of Income Doctrine

Although the cases are sparse, the assignment of income doc-

trine has been applied in a manner consistent with the capital gain
decisions. In Flewellen v. Commissioner, ^^^ a taxpayer who owned a
royalty interest in an oil well made a gift of a production payment of
$3,000 to be paid from the royalties. The Commissioner included the

$3,000 in taxpayer's income, although it had been paid directly to

the donee. The Tax Court observed that had the production pay-
ment been sold, the proceeds would have been taxed as ordinary in-
come under the Lake case."" Inasmuch as the Lake decision rested
on assignment of income principles stated in Horst,^^^ the Tax Court

viewed them as controlling and upheld the Commissioner."^ By

assigning a production payment, the taxpayer attempted to strip off

an income interest from a larger royalty interest which he owned.

Had the taxpayer in Flewellen assigned a vertical slice of his
royalty interest, for example, $3,000 per year for the duration of the

royalty contract, the assignment would have been recognized for tax

'"^311 U.S. 112 (1940).

•"Vrf. at 117.

•"Vd. at 117-18.

'''«356 U.S. at 265.

""32 T.C. 317 (1959).

""/rf. at 322-23.

"'See text accompanying note 108 supra.
"==32 T.C. at 323.



1980] CAPITAL GAIN 487

purposes. ^^^ In United States v. Spalding ^^^'^ the holder of a royalty

interest in a gas well assigned by gift a percentage of all amounts

payable to him in the future under the royalty agreement. Relying

on Blair,^^^ the Court held the transfer effective for tax purposes.

V. Franchises

A. Capital Gain Versus Ordinary Income

Many similarities exist between the tax issues raised by the
disposition of franchises and those pertinent to gas, oil, and mineral

cases. If the transferor of a franchise makes an outright sale retain-

ing no interest in or control over the franchise, it will constitute a

sale or exchange of property and will normally qualify for capital

gain treatment. '^^ An incomplete disposition may be regarded as a
licensing transaction producing ordinary income.

Gowdey v. Commissioner^^'^ illustrates the problems which fre-
quently arise. The taxpayer in Gowdey held a Dairy Queen franchise
for the state of Virginia which gave him the exclusive right to use

patented machines, to use the name "Dairy Queen," and to prepare
and sell the product Dairy Queen. Franchise rights for specified ter-

ritories within Virginia were assigned to various individuals in ex-
change for an immediate lump-sum payment plus periodic payments
of thirty-five cents per gallon of Dairy Queen mix used. The issue
was whether the taxpayer had entered into a subfranchise or licens-
ing arrangement resulting in ordinary income or whether he had

sold a portion of his statewide franchise.

The Court allowed capital gain treatment for the initial pay-
ment, but not for the periodic payments, noting that the assigned

franchise privileges could be exercised in perpetuity."^ Under this
analysis, the taxpayer had transferred to each assignee a portion of

his entire interest, a vertical slice of the statewide franchise con-

sisting of all substantial rights for a specified territory. The court
had some difficulty with the requirement that the taxpayer approve
any subsequent transfer of the franchise, but held that the restric-

tion was insufficient to negate a sale."^

^^^See text accompanying notes 41-46 supra for a discussion of vertical and

horizontal interests in life estates.

"*97 F.2d 701 (9th Cir. 1938).

''^See text accompanying note 41 supra for a discussion of Blair v. Commissioner,

300 U.S. 5 (1937).

""Brook V. Commissioner, 360 F.2d 1011 (2d Cir. 1966); Rev. Rul. 73-428, 1973-2

C.B. 303. The franchise must also qualify as a capital asset under I.R.C. § 1221(1).
"^307 F.2d 816 (4th Cir. 1962).

"7d. at 820.

"«/rf. at 819.



488 INDIANA LAW REVIEW [Vol. 13:463

It is difficult to see why any distinction should be drawn be-
tween the initial payment and the subsequent payments. The fallacy
of this bifurcated approach has been recognized in the mineral

cases/^° A single transaction either does, or does not, constitute a
sale of the franchise. On facts similar to those of Gowdey, the Tenth
Circuit held that all payments qualified for capital gain treatment. '^^

A Fifth Circuit case, Moberg v. Commissioner, ^^^ also involved
transfers of Dairy Queen subfranchises. The consideration for each
subfranchise consisted in part of $4,000, of which $2,000 was payable
at closing with the balance to be paid at the rate of fifteen cents per

gallon of mix used but not less than $1,000 per year. This part of the
consideration would clearly have qualified for capital gain treat-
ment. In addition, the franchiser was entitled to fourteen cents per
gallon of mix used for as long as the franchise existed. The Tax
Court had held all gain except that resulting from the sale of tangi-

ble assets to be taxable as ordinary income, not because of the

royalty arrangement but because of the many restrictions and con-
trols reserved by the taxpayer. ^^^ In the Tax Court's view, these
restrictions and controls gave the taxpayer a continuing interest in

how the franchised businesses were conducted, thereby making the
transactions licensing arrangements rather than sales. ^^* The Fifth
Circuit reversed, noting that "these restrictions were consistent

with a sale of the franchise to use the machine and trademark in an

exclusive territory. The traditional test of ownership is the power to
exclude others and that test was met here."^^^

The court of appeals held that the transaction constituted a sale

but declined to characterize the royalties. ^^^ On remand, the Tax
Court held that the franchises constituted capital assets in the

hands of the taxpayer but that the royalty payments "did not repre-

sent a part of the sales price" and were therefore ordinary income.
^^"^

In a related case,^^^ the Ninth Circuit agreed with the Fifth Cir-

cuit as to one form of the Dairy Queen subfranchise. Regarding a se-
cond form which imposed substantially greater restrictions on the

franchisees, the Ninth Circuit found no sale and held all payments to

be taxable as ordinary income. The distinguishing feature was that

^^See notes 82-87 supra and accompanying text; Consolidated Foods Corp. v.

United States, 569 F.2d 436 (7th Cir. 1978).

'''•Dairy Queen v. Commissioner, 250 F.2d 5031 (10th Cir. 1957).
•'^305 F.2d 800 (5th Cir. 1962).

'''^Moberg v. Commissioner, 35 T.C. 773 (1961).

'"/d. at 784.

'^^305 F.2d at 806.

"Yd. at 784.

'"Moberg v. Commissioner, 32 T.C.M. (P-H) 1 63,288, at 1680-63 (1963).

•''^Moberg v. Commissioner, 310 F.2d 782 (5th Cir. 1962).



1980] CAPITAL GAIN 489

those franchises which resulted in capital gain reserved to the fran-

chiser controls which were designed primarily to assure that the

agreed purchase price would be paid. Those franchises which

resulted in ordinary income reserved to the franchiser more exten-

sive power, including the power to make policy determinations
about how the franchised operation should be conducted.

It is entirely appropriate to allow a franchiser to retain powers

intended to protect the value and reputation of a trademarked pro-

duct without disqualifying the franchise for capital treatment. In

that respect, franchises are different from mineral rights and call

for different rules of taxation. No apparent justification exists,
however, for the difference in the treatment of royalty rights. If, as

Supreme Court decisions have made clear, retention of a right to
royalties based on production is incompatible with a transfer of all

the risks and benefits of ownership and thus precludes a sale when
transfer of a mineral interest is concerned, ^^® the same result should
obtain where a royalty right is retained in connection with granting

a franchise.

This view draws some support from section 1253, adopted by
Congress in 1969 in an attempt to clarify taxation of franchise

transfers. ^^° Under this provision, a transfer of a franchise will not
be treated as the sale of a capital asset if the transferor retains any

significant power, right, or continuing interest in the subject matter

of the franchise. The statute specifies that a continuing interest in-
cludes a right to payments contingent on productivity if such
payments constitute a substantial element under the transfer agree-
ment, thereby contemplating an analysis identical to that developed

by the courts in the oil, gas, and mineral cases. Those cases,

however, have denied capital gain treatment without regard to

whether retained royalty rights were substantial or insubstantial.'^^
The question which arises is whether a sound basis exists for deny-
ing capital gain treatment to oil, gas, or mineral transactions when
royalty rights are retained but denying it to franchise transactions

only when substantial royalty rights are retained.
Some justification for this distinction is found in section 1253(c),

which provides that contingent payments are taxable at ordinary

rates even if the transaction qualifies as the sale of a capital asset.

In other words, if the transferor of a franchise is to receive

payments contingent on productivity which do not constitute a

^^See notes 64-89 supra and accompanying text.

•'"Tax Reform Act of 1969, Pub. L. No. 91-172, § 516(c)(1), 83 Stat. 487.

'''At least one court has suggested that a retained interest of insignificant value

ought not characterize the entire transaction. Wood v. United States, 377 F.2d 300 (5th
Cir. 1967).



490 INDIANA LAW REVIEW [Vol. 13:463

substantial element under the transfer agreement, the transfer may
be treated as a sale, but the contingent payments are nevertheless
taxed at ordinary rates. Thus, section 1253 adopts a bifurcated ap-

proach which may result in part capital gain and part ordinary in-
come treatment. Although the statute provides a more lenient stan-
dard than the oil, gas, and mineral cases in determining whether a
sale of property has occurred, the tax effect of finding a sale under
the statute is less significant. The bifurcated approach reduces the
pressure on the sale versus license issue. Even if a sale has oc-
curred, royalty income is taxed at ordinary rates. A similar statutory
rule would be as desirable in the oil, gas, and mineral area as it is in the

franchise area. It would prevent the characterization of an entire

transaction by a retained royalty which may be an insubstantial part
of the total consideration received.

B. The Assignment of Income Doctrine

No case has been found concerning the tax consequences of
assigning a portion of a franchise by gift. Presumably, a vertical

slice of a franchise could be effectively transferred. Thus, if one

holds the right to make and sell Dairy Queen products in a five-state
area, an unconditional assignment of the franchise pertaining to one

of the states should be recognized for tax purposes.

If the donor retained some control over use of the franchise by
the donee or assigned the franchise for a limited period of time, the

issue would be whether the interest assigned was a mere right to in-
come. If the interest transferred would have qualified for capital

gain treatment had a transfer in exchange for a lump sum payment
of cash occurred, the interest should be regarded as a gift of income-

producing property with income subsequently produced taxed to the

donee. On the other hand, if the donor retained control over opera-
tion of the franchised business, income may well be attributable to
the continuing supervision of the donor and appropriately taxed to

the donor.

VI. Contracts

A. Capital Gain Versus Ordinary Income

1. Service Contracts. — Courts have consistently denied capital
gain treatment to income arising out of pure employment contracts. ^^^

As the Tax Court recently stated: "It is a well settled principle of
law 'that consideration received for the transfer of a contract right

''^See, e.g.. Holt v. Commissioner, 303 F.2d 687 (9th Cir. 1962); Flower v. Commis-

sioner, 61 T.C. 140 (1973); Heyn v. Commissioner, 39 T.C. 719 (1963); McFall v. Commis-

sioner, 34 B.T.A. 108 (1936).



1980J CAPITAL GAIN 491

to receive income for the performance of personal services is tax-

able as ordinary income/"*^^ The principle applies equally to
payments for cancellation of an employment contract not yet per-
formed.^^*

In many instances, transactions will include not only cancellation
or transfer of a service contract but also transfer of an interest in a

number of other assets, tangible or intangible, some of which would
yield capital gain if sold separately. Transactions of this kind have

produced litigation and confusion.

In Jones v. Corbyn,^^^ the taxpayer had an agency contract with

an insurance company under which he had the exclusive right to
solicit customers in the state of Oklahoma. When difficulties
developed, the insurance company paid the taxpayer $45,000 in ex-
change for termination of the agency contract, all books, records,

and files pertaining to the business, and rented office space from

which the business had been conducted. The Commissioner argued
that the agency contract was simply a right to perform services
which would have generated ordinary income. The Tenth Circuit
disagreed, concluding that the contract was a form of intangible prop-
erty within the meaning of the capital gain provisions. ^^®

In a subsequent case, Elliott v. United States,^^^ the Tenth Cir-

cuit declined to follow its decision in Jones v. Corbyn, observing

that the decision had been criticized by several courts and at least

one commentator. ^^^ Elliott arose out of the merger of two insurance
companies. The taxpayer had made an agreement with the surviving
company to terminate his general agency contract with the merging
company in exchange for nearly $50,000 plus a percentage of
business produced under the contract prior to its termination. Ac-

cording to the termination agreement, the lump sum payment was
for personal money invested in the business by the taxpayer. Never-
theless, the court held the $50,000 taxable as ordinary income,

stating that personal money was expended by him to pay cur-
rent operating expenses which he intended to recoup through com-

'^'Goldman v. Commissioner, 44 T.C.M. (P-H) 1 75,138, at 628-75 (quoting Flower v.

Commissioner, 61 T.C. 140, 148 (1973), aff'd, 50 F.2d 1302 (1974)) (lump sum received in
exchange for release of all claims arising under partially performed employment con-

tract held ordinary income).

'^*McFall V. Commissioner, 34 B.T.A. 108 (1936) (lump sum received by employee
for cancellation of five-year employment contract with three years remaining held or-

dinary income).

''^86 F.2d 450 (10th Cir. 1950).

'''Id. at 452.

'"431 F.2d 1149 (10th Cir. 1970). See also Vaaler v. United States, 454 F.2d 1120

(8th Cir. 1972).

''«431 F.2d at 1154.



492 INDIANA LA W REVIEW [Vol. 13:463

missions that would have been ordinary income. ^^^ Because the lump
sum was received in exchange for relinquishing the right to earn or-
dinary income, application of the substitution doctrine was deemed
appropriate.

A similar problem arose in the Fifth Circuit case of Nelson
Weaver Realty Co. v. Commissioner.^^^ A mortgage banking com-
pany had entered into a contract with a life insurance company for
placing and servicing the insurance company's mortgage loans.

Under the arrangement, the taxpayer agreed to make mortgage
loans which it deemed to be sound and sell them to the insurance
company as the permanent lender. For an agreed fee, the mortgage
company collected periodic payments of principal and interest, ar-

ranged for payment of insurance and property taxes, and performed
other routine services. This contract was assigned to another mort-

gage banker for $121,841. The assignee acquired all rights under the
contract, including the right to service approximately 1,830 mort-

gages, and all business records pertaining to the contract. Although

the Commissioner argued that the lump sum was a substitute for
fees to be earned in the future which should be taxed as ordinary in-

come, the court found no correlation between future income which

would have been derived from servicing the loans and the purchase

price. This lack of correlation and the fact that the taxpayer had

transferred to the buyer business records which had been compiled

over the years in connection with mortgage loans, including a cus-
tomers list, persuaded the court to conclude that a longstanding

relationship with a satisfied clientele, the equivalent of goodwill, had

been sold. Accordingly, capital gain treatment was upheld. ^^^

In Weaver Realty, the Fifth Circuit characterized the transac-
tion as a whole. Because the consideration was not entirely a
substitute for ordinary income, the court did not apply the substitu-

tion for income doctrine. This approach was promptly abandoned in
Bis bee-Baldwin Corp. v. Tomlinson.^^'^ On facts similar to those in-
volved in Weaver Realty, the court held that the proceeds were or-
dinary income to the extent attributable to servicing mortgage loans

and capital gain to the extent attributable to goodwill or other

valuable interests qualifying as capital assets.
*^^

'''Id. at 1153.

'*°307 F.2d 897 (5th Cir. 1962).

'''Id. at 901.

'"320 F.2d 929 (5th Cir. 1963).

"Hd. at 934-36. See also United States v. Wollsey, 326 F.2d 287 (5th Cir. 1963)

(gain realized on sale of a business involving the management of mutual insurance com-

panies taxed partly as ordinary income, partly as capital gain); United States v.

Edison, 310 F.2d 111 (5th Cir. 1962) (gain realized on sale of an insurance business car-

ried on under a general agency contract taxed at ordinary rates).



1980] CAPITAL GAIN 493

Finally, in Flower v. Commissioner, ^'^^ the Fifth Circuit affirmed a

Tax Court decision holding amounts received in exchange for ter-

mination of a selling contract to be ordinary income. '^^ The taxpayer

had received a lump sum payment for termination of a contract
under which he was to promote and sell the products of a drug

manufacturer. The taxpayer urged that he had disposed of assets
other than the terminated contract, including goodwill, and that the

sale price should be allocated among such assets with any gain at-
tributable to capital assets taxed at capital rates. The court rejected

this argument on the theory that any goodwill generated through
the taxpayer's efforts attached to the manufacturer's products, not

the taxpayer's business, and thus could not have been transferred

by the taxpayer.^** In addition, the court observed that the taxpayer

did not transfer a franchise, he simply released a contract right to

earn ordinary income, and that as a general principle consideration

received for the transfer of a contract right to receive income for

the performance of future services is taxable as ordinary income. ^^^

As the foregoing cases demonstrate, the courts have employed
property and agency laws in characterizing transactions which in-

volve the disposition of service contracts plus other valuable rights.

For example, in Flower the court emphasized that the taxpayer was
the agent of another so that as a matter of law any goodwill or

business records developed by the taxpayer did not belong to him

but to his principal. ^^* Thus, the taxpayer lacked a property interest

to which a portion of the consideration could be allocated. In Bisbee-

Baldwin, however, the taxpayer was accorded partial capital gain
treatment because he had developed goodwill and business records

under a contract as a nonagent.^^^

The distinction based on agency and property law is artificial
and unpersuasive. The Supreme Court has frequently admonished
that the answer to capital gain problems is not to be discovered in
concepts of property law or other local law which may vary from
state to state. ^^^ As a matter of substance, the taxpayers in all these

•"505 F.2d 1302 (5th Cir. 1974), aff'g mem. 61 T.C. 140 (1973).
'*^61 T.C. 140, 149 (1973), aff'd mem., 505 F.2d 1302 (1974).
'*'Id. at 150.

'*Ud. at 151. See, e.g., Furrer v. Commissioner, 45 T.C.M. (P-H) 1 76,331 (1976), 115
(9th Cir. 1977) (capital gain denied on facts similar to those in Flower),

•*«61 T.C. at 150.

'^'320 F.2d at 934.

'^'"'It is the will of Congress which controls, and the expression of its will in
legislation ... is to be interpreted so as to give a uniform application to a nationwide

scheme of taxation. . . . State law may control only when the federal taxing act, by ex-
press language or necessary implication, makes its own operation dependent on state
law." Burnet v. Harmel, 287 U.S. 103, 110 (1932) (citations omitted).



494 INDIANA LAW REVIEW [Vol. 13:463

cases were doing business under a contract and were able to negoti-
ate for a payment in exchange for relinquishing their contractual
rights. Regardless of who owned the business records and goodwill,
the taxpayer in each case was entitled to their use and benefit so
long as the contract endured and was being compensated for the
surrender of that valuable right. The fact that ordinary income
would have been realized had the taxpayer continued to conduct

business should not be controlling. One who sells inventory in the
ordinary course of his business also earns ordinary income. That

does not preclude capital gain treatment when the business is liqui-
dated and the inventory sold in bulk. Similarly, the liquidation of

valuable contractual rights should not preclude capital gain treat-

ment merely because the rights would have produced ordinary in-
come if retained.

For the same reasons, the pure employment contract cases^^'
have not been decided on a principled basis. The absence of business
records, goodwill, or some other property aside from the contract
itself should not result in automatic denial of capital gain treatment.

That amounts received in exchange for service contracts are
substitutes for ordinary income should not be conclusive. The sale of
inventory or the sale of stock for a price determined by expected

dividends could also be described as a substitute for income.

It seems the assignment of income cases which flatly preclude

the gratuitous assignment of earned income^^^ have had an unfor-

tunate impact here. Preserving the integrity of progressive taxation

provides an adequate basis for an absolute prohibition on the assign-

ment of income to be earned in the future by the assignor. That ra-
tionale does not extend to the capital gain area where one is giving

up not only the right to receive income but also the right to earn

future income. Following a gratuitous assignment of income, the

assignor renders services but the assignee collects the income. Ob-

viously, the assignor should be taxed. Similarly, if one sells his right

to income from future services under an employment contract for a
lump sum and thereafter renders the services with the assignee col-
lecting the income, the assignor should be taxed at ordinary rates

on the lump sum because it is a mere substitute for periodic
payments. The employment contract continues to exist and the

assignor continues to render services. But if more is involved — if all
rights, including the right to render services under an employment

'^'5ee text accompanying notes 132-34 supra.

^^^E.g., Lucas v. Earl, 281 U.S. Ill (1930). In what has become a famous metaphor,

Justice Holmes declared he could think of no reason "by which the fruits are at-

tributed to a different tree from that on which they grew." Id. at 115. The flat rule

taxing all earned income to whoever earned it has endured. See United States v.

Basye, 410 U.S. 441 (1973).



1980] CAPITAL GAIN 495

contract, are liquidated for a lump sum — a right to earn a flow of in-
come in the future is exchanged for its present value, a transaction

no different from any sale of income-producing property. In the final

analysis, all income-producing property is equal to the present value

of the future income it is expected to produce. '^^ Thus, all sales of

income-producing property involve the substitution of a lump sum

for a flow of future income. Unless the substitution doctrine is

limited to transactions not involving a termination of interest, it vir-

tually swallows the capital gain provisions.

Furthermore, the substitution doctrine was developed to deal
with transactions not involving a complete termination of interest

because such transactions are outside the intended scope of the

capital gain provisions. They do not involve the realization in a
single year of the entire income the taxpayer will ever realize from

the property. If a complete bunching of income occurs, as in the ter-

mination of an employment contract, the transaction is within the
principal purpose of the capital gain provisions: to ameliorate the ef-

fect of progressive taxation on bunched income. Application of the

substitution doctrine is incompatible with the purpose it was intended
to serve. Finally, the Tax Court is incorrect in suggesting that Lake
dictates ordinary income treatment whenever a lump sum payment
is realized in lieu of periodic payments taxable at ordinary rates. ^^*

Capital gain treatment was denied in Lake, as in Hort, because
income-producing property was not entirely disposed of. Under such
circumstances the transferred interest was properly regarded as an
income interest subject to the substitution doctrine. If a taxpayer

with a ten-year employment contract sold the right to income for
five years, the transaction would not be a termination of the

employee's rights and duties under the contract but a mere collaps-
ing of income and the Lake rationale should apply. However, the
Lake rationale clearly should not control the cancellation of an
employment contract which involves a complete termination of all
economic interests in the contract. Under such circumstances, even-
handed treatment of wage earners and property owners demands
capital gain treatment for the termination payment except to the ex-
tent that it constitutes payment for past services.

'**As graphically stated by the court in United States v. Dresser Indus., 324 F.2d

56 (5th Cir. 1963), "[tjhe value of a vending machine, as metal and plastic, is almost nil;

its value arises from the fact that it will produce income." Id. at 59.

'""In Flower v. Commissioner, 61 T.C. 140 (1973), the Tax Court found "strong sup-

port" in Lake for the following proposition: "[T]he consideration petitioner received for

termination of his contract was a substitute for ordinary income he would have re-

ceived had the contracts not been terminated, and nothing else. Thus, we conclude, the
entire amounts received are taxable as ordinary income . . . ." Id. at 149.



496 INDIANA LAW REVIEW [Vol. 13:463

2. Contracts Other than Service Contracts. — Contra.cts in
which the rendition of services played a subsidiary role have fared

only slightly better under the capital gain provisions. Many of the
decisions turned on whether the contract right was regarded as
"naked," or as a ''substantial property right." Under this approach,
contract rights qualify as a capital asset only if they create a direct

interest in something conventionally regarded as property, such as a
leasehold in real estate, or a life estate in a trust corpus consisting

of securities. ^^^ Contracts which do not create such interests are said

to be "naked" and therefore not property for purposes of the capital

gain provisions.

The Second Circuit applied this analysis in Commissioner v. Pitt-
ston Co.,'^^^ characterizing as ordinary income a lump sum received
by the taxpayer for release of its right to purchase all coal produced

by a certain plant at eight percent below the market price. ^^^ The
court stated that "[t]he courts have not been entirely consistent in

their treatment of lump sum payments received by a taxpayer for
the termination of jural relations . . . ."^^® Indeed, the Tax Court in

Pittston had upheld capital gain treatment, ^^^ and Judge Moore,

dissenting from the Second Circuit's decision, concluded that the

"contract rights can only be rendered 'naked' by stripping from them
and discarding the raiments which the parties found to be essential."®"

One of the most carefully reasoned opinions in this area is Com-
missioner V. Ferrer?^^ The taxpayer had acquired the exclusive right
to produce a stage play based upon a copyrighted novel, the power
to prevent the sale of film rights in the novel for a specified period

of time, and, if he in fact produced a play, the right to share in any

proceeds subsequently generated through film rights. In exchange

for cancellation of these contract rights, the taxpayer received a

right to seventeen percent of the net profits realized from produc-

tion of a movie. The Commissioner contended that the entire royalty
was taxable at ordinary rates. The Second Circuit Court of Appeals
reviewed the cases involving the tax treatment of amounts received

'^^See Dorman v. United States, 296 F.2d 27 (9th Cir. 1961); Metropolitan Bldg. Co.
V. C.I.R.. 285 F.2d 592 (9th Cir. 1960); C.I.R. v. Golonsky, 200 F.2d 72 (3d Cir. 1952),

cert, denied, 345 U.S. 939 (1953).

'^"252 F.2d 344 (2d Cir. 1958).

"/d. at 348.

'''Id. at 347.

•'''Pittston Co. V. Commissioner, 26 T.C. 967, 969 (1956).

•*"'252 F.2d at 349 (Moore, J., dissenting). See Commissioner v. Goff, 212 F.2d 875

(3d Cir. 1954) (surrender of contract rights to the entire product of four machines a

capital gain transaction).

•"•304 F.2d 125 (2d Cir. 1962).



1980] CAPITAL GAIN 497

in exchange for contract rights and described the "naked" versus

"substantial" analysis:

One common characteristic of the group [of transactions]
held to come within the capital gain provision is that the tax-
payer had either what might be called an "estate" in ... or
an "encumbrance" on ... or an option to acquire an interest

in . . . property which, if itself held, would be a capital asset.

In all these cases the taxpayer had something more than an
opportunity, afforded by contract, to obtain periodic receipts

of income, by dealing with another ... or by rendering ser-

vices ... or by virtue of ownership of a larger "estate."'
'162

Accepting this analysis, the court categorized the various interests

held by the taxpayer as either capital gain or ordinary income by

examining the character of the transaction.^®^ The court noted that
the play production right "sounds like the transactions held to

qualify for capital gain treatment."^®'' The court theorized that the in-
terest resembled a lease or an equitable interest, which is more than
a contract right to earn income by rendering services. ^®^ In addition,

the court observed that the production right is intimately related to

the copyright of the play, which is a capital asset. ^^^ The court thus
rejected the Commissioner's substitution for income argument,

stating that payment in exchange for relinquishment of the right to
produce a play could qualify for capital gain even though exercise of
the right would have generated ordinary income. ^^^

Similarly, the court decided that the taxpayer's right to prevent

the sale of motion picture rights for a specified period of time con-

stituted an equitable interest in the author's copyright over motion

picture rights. ^®® The court held that relinquishment of that interest

should be taxed at capital gain rates, ^^^ producing the same result as

''^Id. at 130-31 (citations omitted).

'*^The court rejected the wholly unsatisfactory approach it had taken earlier in

Commissioner v. Starr Bros., Inc., 204 F.2d 673 (2d Cir. 1953), and General Artists

Corp. V. Commissioner, 205 F.2d 360 (2d Cir. 1953). In these cases, the court had fo-

cused upon whether the interests relinquished had survived the transaction, thereby

meeting the sale or exchange requirement, or had been extinguished. This approach

would seldom result in capital gain treatment upon cancellation of a contract because

the interests are normally extinguished. As the Ferrer court recognized, the parties to
the transaction generally will "not care a fig whether there was an 'annulment or con-

veyance.'" 304 F.2d at 131.

"'304 F.2d at 131.

'''Id. at 132.

'*Tor a more recent application of the same analysis, see Crisp, 42 T.C.M. (P-H) 1
73,006 (1973).

"^304 F.2d at 132.

"«/d. at 133.



498 INDIANA LAW REVIEW [Vol. 13:463

the transfer of the entire copyright, rather than a limited interest

relating to the copyright. When considering the right to share in
profits derived from the sale of movie rights, the court reached the
opposite result. The contract provided that the taxpayer was to
have "no right, title or interest, legal or equitable, in the motion pic-

ture rights, other than the right to receive"^^" a share of the pro-

ceeds. Because the author expressly retained all property rights

relating to producing a motion picture, the taxpayer had nothing

more than a right to a share of future income which would have
been taxed at ordinary rates. Relying on Hort and the substitution
for income arguments, the court held that the amounts received in
exchange for release of the percentage rights constituted ordinary

income. ^^^

In deciding the tax treatment of gains from the sale of

covenants not to compete, the courts have relied upon property law

concepts. In the words of the Second Circuit:

It is well established that an amount a purchaser pays to
a seller for a covenant not to compete in connection with a
sale of a business is ordinary income to the covenantor and

an amortizable item for the covenantee unless the covenant

is so closely related to a sale of good will that it fails to have

any independent significance apart from merely assuring the

effective transfer of that good will.^^^

Thus, the capital gain treatment depends on the relationship of

the covenant to some other item, usually goodwill, conventionally
recognized as a property interest. It is difficult to conceive how a
covenant not to compete given by the seller of a business can be

anything but ancillary to the sale of business assets."^ Nonetheless,

many cases have denied capital gain treatment on the theory that
the covenant was severable from the sale of other assets. ^^^ If the
covenantor is a shareholder in the corporation which sold business

assets, capital gain treatment has generally been denied on the

grounds that the covenantor sold no assets to which the covenant

could be ancillary. ^^^ This result, grounded on the corporate law con-

cept of the corporation as a separate entity, ignores the economic

'''Id. at 134.

'^'UUman v. Commissioner, 264 F.2d 305, 307-08 (2d Cir. 1959).

"'See 3B J. Mertens, Law of Federal Income Taxation § 22.33, at 297 (1977).
""See, e.g., Barran v. Commissioner, 334 F.2d 58 (5th Cir. 1964).

"^Montesi v. Commissioner, 340 F.2d 97 (6th Cir. 1965); Hamlin Trust v. Commis-

sioner, 209 F.2d 761 (10th Cir. 1954).



1980] CAPITAL GAIN 499

unity of the corporation's business and the shareholder's business

which made the shareholder covenant necessary. Stripped of its
technicalities, most, would agree the result is unfortunate.^^®

The answer to capital gain issues should not be sought in the

law of corporations any more than in the law of property or agency.
The convoluted reasoning of the lower courts has led to conflicting

and inappropriate results and has increased tremendously the com-

plexity of the characterization process. Proper analysis would follow

the simpler lines of Hort and Lake. If there were a complete disposi-

tion of whatever valuable rights the taxpayer owned, the transac-

tion would fall within the intended scope of the capital gain provi-

sions. ^^^ If the disposition were incomplete, there would be no sale of
property rights, merely an arrangement for their exploitation.

Under the termination of interest test, the result of many of the
cases considered above would be altered. For example, the taxpayer

in Pittston Co. liquidated its entire contract right for a specified

sum of money and would qualify for capital gain treatment under
the termination of interest test. To deny capital gain treatment for
such a transaction when the liquidation of other forms of valuable
interests qualify, is arbitrary and unfair. In Ferrer the tax-

payer held three contract rights, one relating to production of a

stage play and two relating to production of a motion picture. Only
the first was liquidated and only it should have qualified for capital
treatment. The taxpayer, in effect, exploited the other contract
rights by relinquishing them in exchange for a share of profits real-
ized from production of a movie. On the other hand, covenants not
to compete would generally qualify for capital treatment since they

normally involve a complete relinquishment of the right to compete

during the term of the covenant — the covenantor's consideration is
not usually dependent upon the covenantee's profits.

B. Assignment of Income Doctrine

Rights and duties under a personal service contract cannot be

assigned by gift. One can assign the right to collect payments for
the rendition of services, but the assignment is ineffective for tax

purposes. The assignor will be responsible for the taxes on any in-
come earned by his services even though the income is collected by

""Sec 3B J. Mertens, supra note 173, at 300.
"^Of course, limitations unrelated to those discussed here may preclude capital

gain treatment. See, e.g.. Corn Prods. Ref. Co. v. Commissioner, 350 U.S. 46 (1955)

(transactions which are an integral part of a trade or business do not qualify for capital

gain treatment).



500 INDIANA LAW REVIEW [Vol. 13:463

the assignee/^® This practice is consistent with ordinary income

treatment for any lump sum received in lieu of periodic payments
for past or future services.

'^^

Contracts which do not involve the retention of services by the
transferor should be freely assignable by gift for income tax pur-

poses, subject to the usual termination of interest rule. Even a con-
tract right productive of ordinary income in the hands of the donor

should be assignable. Such treatment is consistent with the Blair
ruling concerning an assignment of a life estate^^° and should not de-
pend on whether the contract right is deemed "naked" or "substan-
tial." The "naked" versus "substantial" test is irrelevant to the pur-
pose of the assignment of income doctrine which prevents frustra-

tion of progressive taxation by splitting income among taxpayers.
No splitting of income occurs when one transfers his entire interest.
The donee may be in a lower tax bracket than the donor, but no
sound reason exists for precluding assignment of an entire contract

right to a low-bracket donee while permitting assignment of other

income-producing property to such a donee. Nevertheless, the courts

are likely to apply the analysis of Pittston, Ferrer, and the

covenant-not-to-compete cases. If the courts adopt this approach,

assignability would depend on the "naked contract" versus "substan-
tial property interest" test.'181

VII. Conclusion

Equity and simplicity should be goals of any area of the law.

Although not mutually exclusive, the two concepts often clash. If
capital gains were taxed at the same rates as ordinary income, sim-
plicity would be achieved but inequities created because gains ac-

cumulated over a period of years would be taxed in a single year

according to a progressive rate structure. Thus, equity may require
a certain degree of complexity.

The Supreme Court's decisions provide a coherent theory in
which transfers of income-producing interests are recognized for

capital gain and assignment of income purposes if the transfer ter-

minates the taxpayer's interest in the transferred property. This

theory is not only easy to understand and apply, but also is consis-

tent with the underlying purposes of capital gain treatment and the

assignment of income doctrine. If one has not terminated his in-

terest in property, all income to be realized from the property is not

assessed in a single year, and capital gain treatment is appropriately

'^«Lucas V. Earl, 281 U.S. Ill (1930).

"'See text accompanying note 152 supra.

^^"See text accompanying note 41 supra.

'*The author has found no cases involving gifts of this interest.



1980] CAPITAL GAIN 501

withheld. Similarly, transfer by gift of less than one's entire interest

in property results in a splitting of income between donor and

donee. The transfer should be disregarded to preserve the integrity

of the progressive rate structure. The termination of interest rule
produces equitable results if applied uniformly without regard to

the nature of the property in question.

Lower court decisions are another matter. In dealing with cer-

tain types of property interests, such as franchises and contractual

rights, which the Supreme Court has not considered specifically, the
lower courts have applied ambiguous and specious standards in con-
struing the capital gain provisions. They have made the relatively
simple process of characterizing a transaction for capital gain or

assignment of income purposes, complicated, speculative and, to a

large degree, unpredictable. Furthermore, the selection of different

standards for different types of interests ignores equitable concerns.

Arbitrary distinctions have led to arbitrary and inequitable results.

Simplicity and equity need not be sacrificed if the lower courts

adopt the guiding principles of Hort, Blair, Lake, and other Supreme
Court decisions.