DEFINITION OF CAPITAL

ASSETS--SEC. 1221

The IRC defines capital assets in a negative sense, stating only that capital assets are property held by the taxpayer, whether or not connected with his or her trade or business except for certain items. The list of non-capital assets is as follows:

1. Property that is inventory or held primarily for sale by the taxpayer to customers in the ordinary course of trade or business.

2. Depreciable property or land used in a trade or business.

3. A copyright; a literary, musical, or artistic composition; a letter of memorandum, or similar property, if held by a) a taxpayer whose personal efforts created such property, b) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or c) a taxpayer in whose hands the basis of such property is determined, for purposes of determing gain from a sale or exchange, in whole or in part, by reference to the basis of such property in the hands of a taxpayer described in (a) or (b) (e.g., a nontaxable exchange).

4. Accounts or notes receivable acquired in the ordinary course of doing business.

5. Certain U.S. government publications.

Of these exclusions, the first has been subject to the most interpretation, especially with respect to the definition of "primarily." The various courts have been undecided as to whether "primarily" meant mainly or merely substantially. The Supreme Court in Malat v. Riddell (1966) helped to remove the uncertainty by holding that "primarily" for purposes of Sec. 1221 means the same as it does for everyday usage, namely "of first importance" or "principally."

The regulations add little to the definition. They do make it plain that depreciable property not used in a trade or business may qualify as a capital asset. They also expand somewhat the definition of "similar property."

THE CORN PRODUCTS CASE

Taxpayers, of course, wish for a narrow view of capital assets when they incur losses and a broad definition when they have gains. Conversely, the IRS prefers a broad definition of capital assets in loss transactions and a narrow definition when gains are realized by taxpayers. Thus, neither side will be completely happy, no matter how the Supreme Court and the lower courts define capital assets. In Corn Products Refining Co., the company wanted to treat income realized from hedging in commodity futures as capital gains. However, in ruling against the taxpayer, the Court said, ". . . the definition of a capital asset must be narrowly applied and its exclusions interpreted broadly." The court considered this necessary because "the preferential treatment provided capital assets . . . applies to transactions which are not the normal source of business income." The specific result of Corn Products was to deny preferential treatment to gains from hedging transactions. However, as will be discussed later, Corn Products was also cited to permit ordinary loss deductions where the IRS asserted that a loss should be a capital loss.

THE ARKANSAS BEST CASE

In Arkansas Best, a bank holding company had purchased additional stock in a bank, not for investment purposes, but for the business purpose of protecting the company's reputation by preventing the bank's failure. In seeking ordinary loss deduction for its losses on the sale of such stock, the company argued that the term "property held by the taxpayer, whether or not connected with his trade or business" does not include property that is acquired and held for a business purpose, asserting in effect that the asset's status as "property" turned on the motivation behind the decision. However, the court held that the taxpayer's motivation in purchasing an asset is irrelevant to the question of whether it falls within the broad defintion of capital assets, and that the judicial application of Corn Products to analyze motive was an unwarranted expansion of Corn Products.

Hence, the court opted for a broad definition of capital assets as opposed to its definition in Corn Products and considered the five exclusions from capital assets in Sec. 1221 to be exhaustive rather than illustrative. The court did state that in applying some of the exceptions, a "close connection" between an option and inventory might be sufficient to treat the option as a surrogate for inventory and thus be eligible for ordinary gain/loss treatment.

The court somewhat disingenuously said that this decision was not inconsistent with Corn Products, stating that Corn Products applied only to commodity hedges. In fact, the court in Corn Products said that the definition of capital assets must be defined narrowly, while in Arkansas Best the court defined capital assets in a broad sense. The Corn Products did not just apply to commodity hedges is amply illustrated by the plethora of cases unrelated to commodity futures that have cited Corn Products. A later section of this article contains a discussion of cases that would likely have been decided differently with Arkansas Best as a precedent.

APPLYING ARKANSAS BEST TO

OTHER CASES

As might be expected, a number of court cases subsequent to Arkansas Best have cited the case. In Barnes Group, Inc. (1988) the company had entered into a foreign currency contract to offset a contract to sell. The purpose of the contract was to offset losses it expected from its ownership of a Swedish company due to expected currency devaluations. The company sought to deduct the losses as ordinary and cited as precedent a tax court case, Hoover Co. v. Comr., 72 TC 206 (1979), which had similar facts. The district court however, said that Hoover must be reexamined in light of Arkansas Best.

In Buthcher (1989) the U.S. Bankruptcy Court held that a banker's investment in stock was a capital asset, not a business asset, and, therefore, interest and other expenses were investment expenses. The banker who controlled and operated several banks asserted that he was in the business of banking and, therefore, the bank stock was a business asset. In rejecting this argument, the court cited Arkansas Best. In Olson (1989) the Tax Court found that the sale of stock in financial institutions, even though deemed an integral part of taxpayer's business, did not fit any of the narrow--post-Arkansas Best--exclusions from capital asset treatment. The stock was not inventory, nor was it held for sale in the taxpayer's business, nor was it subject to wear and tear, exhaustion, or obsolescence. Note how this contrast with previous cases decided under Corn Products such as Hagan (1963) where the taxpayer, a salesman, purchased stock in a corporation, and, as part of the purchase agreement, received exclusive sales rights to certain of the corporation's products. When the corporation became insolvent, an ordinary loss deduction was allowed by the court, because of the business intent shown by Hagan in purchasing the stock.

The potential wide-sweeping effect of Arkansas Best is illustrated in the Azur Nut Company case. As a precondition to accepting an executive position with the company, the individual demanded and was given protection against a possible loss on the sale of his house. Eventually, the executive was terminated and the company realized a loss of $111,366 on the sale of his house; the company purchased the house from the executive for an agreed upon price of $285,000. Although the company advanced several arguments to buttress its position that the loss was ordinary rather than capital, the argument related to Arkansas Best was that the house purchase satisfied a business need and that it was therefore deductible in full as an ordinary and necessary business expense. The Tax Court however, citing Arkansas Best, said that the motive of the taxpayer was not relevant in determining the status of the taxpayer. Since the asset was not "used in" the trade or business, (although its purchase was connected with the trade or business), it was a capital asset. The Fifth Circuit, in affirming the decision, said that the phrase "used in a trade or business," which, if applicable, would exclude capital asset treatment if the assert were also depreciable, does not suggest that an asset may be excepted from capital asset treatment simply because the asset is acquired with a business purpose. Ratheer, the asset must be actually used in the taxpayer's business. Therefore, if the asset has no meaningful association to the taxpayer's business, it does not meet the "used in" test.

This case will probably discourage companies from directly purchasing houses of executives. In the future, a guarantee against loss will likely be structured in other ways.

FUTURE IMPACT OF

ARKANSAS BEST

A number of court cases cited Corn Products in deciding that a given transaction generated ordinary income or loss. If these cases were decided today, a much different decision might be rendered. In Campbell Taggart (1984), a holding company whose subsidiaries were engaged in the manufacture of food products took an ordinary loss deduction for the sale of stock in a Spanish supermarket chain. The Fifth Circuit held thqat the holding company had a business motive in purchasing the stock, and that under Corn Products the loss was ordinary. This case would surely be decided differently today. In Becker-Warburg Paribas (1981) a brokerage firm was allowed to deduct as an ordinary loss the sale of a seat on the New York Exchange because the purpose of the acquisition was to enhance its business. Under Arkansas Best the existence of a business purpose would not affect the decision as to whether the stock exchange seat was a capital asset. In Union Pacific (1975) the Court of Claims held that the railroad's holding in a subsidiary was for business purposes and was, therefore, not a capital asset. In Electrical Fittings (1960) the taxpayer, a manufacturer of electrical conduit fittings, joined with three other parties to build a foundry to produce iron castings, its supply of castings had been unreliable. Relying on Corn Products, the Tax Court held that the taxpayer held stock in the foundry only to obtain an adequate supply; hence, this was a business, not an investment, motive and the loss on the sale of the stock was ordinary. The Court of Claims ruled similarly in Booth Newspapers (1962).

Under Corn Products, securities in many instances, in addition to those cited, were held not to be capital assets when the intent of purchasing was business rather than investment. By ruling in Arkansas Best that intent is not relevant, the Supreme Court appears to have placed stock and securities firmly within the capital asset definition, regardless of the motivation in acquiring those securities.

HOW WILL THE QUESTIONS

BE ANSWERED?

Although Arkansas Best has, by affirming up the definition of capital asset, removed much of the latitude for judicial interpretation in this area, many questions remains. Will the courts be symmetric in applying Arkansas Best, i.e, will they be as likely to interpret the exclusion narrowly in the case of gains as losses? Will any exceptions to capital asset treatment for stock or securities be granted by the courts after Arkansas Best, e.g., critical supply needs of the business? Will the stricter and narrower construction of exclusions from capital asset treatment affect the definition of property? The courts have sometimes denied capital asset treatment to taxpayers on the grounds that the transaction did not involved the sale of "property." For example, money received to indemnify for the invasion of privacy--e.g., the sale of rights to a life story--has been held not to be property.

Will the courts be more likely to treat these items as the sale of property, thus qualifying for capital gains?

To some extent, Congress is to blame for the confusion. As mentioned, Sec. 1221 contains no positive definition of capital assets, only a list of what capital assets are not. With only a negative definition, there is no conceptual foundation upon which to build well-reasoned administrative and judicial decisions. Taxpayers would be well served if Congress rewrote Sec. 1221 to describe what a capital asset is as well what it is not. Perhaps Congress should also consider expanding the definition of Sec. 1231 assets. The harsh restrictions on capital loss deductions appear unfair when applied to the disposition of business assets. It is not readily apparent why the sale of some business assets should yield unrestricted deductions--Sec. 1231 losses-- when the sale of other business assets should, in the absence of capital gains, result only in a loss carryforward. The whole area of capital and Sec. 1231 assets should be reexamined.

RECENT DEVELOPMENTS--THE

CIRCLE K CASE

Recall that in Arkansas Best, the Supreme Court said that the motivation in purchasing an asset is irrelevant to the question of whether it falls under the definition of a capital asset. Thus, the Court of Claims decision on Circle K Corporation in 1991, at first glance, appears very surprising. In Circle K, the company, a convenience store chain that also sold gasoline, was experiencing difficulty in obtaining adequate supplies of gasoline. Therefore, the company purchased about 12% of the stock in NuCorp Energy, Inc., an oil company. Circle K also entered into an exploration and development agreement under which it would acquire a 10% operating interest in all future oil and gas exploration and development activities of NuCorp.

The next year, Circle K turned back all interest in drill sites and leases to NuCorp in exchange for additional stock. As part of the agreement, Circle K received an option to purchase crude oil from NuCorp. Circle K never actually used the option, and later NuCorp ran into financial difficulties, eventually filing Chapter 11 reorganization. Subsequently, Circle K sold the stock at a sizeable loss, and deducted the loss as ordinary. After the IRS, on audit, recategorized the ordinary loss deduction as a capital loss, Circle K was denied a claim for a refund. It then sued for the refund in the Court of Claims. The Court of Claims, while recognizing that the Supreme Court in Arkansas Best widened the definition of a capital asset, noted that the Supreme Court continued to uphold Corn Products with respect to hedging transactions, i.e., continued to permit ordinary loss deductions for hedging transactions. The Claims Court noted that the "source of supply principle"--situations where corporate stock is purchased by the company in order to obtain access to raw materials--was not directly addressed by Arkansas Best and, thus, may still be valid. Therefore, if a source of supply stock purchase has a "substantially close connection" to the business so as to be an integral part of the inventory-purchase system, the transaction would qualify as a hedging transaction. In holding for Circle K, the Claims Court held that the investment in and agreement with NuCorp did have a substantially close connection to the business to qualify under the inventory exception. The Claims Court so ruled despite the fact that no inventory transaction ever took place.

HAVE THINGS REALLY

CHANGED?

What are the implications of Circle K? Does it represent a step back to the body of cases that extended Corn Products to analyzing the motive of transactions? Or, does it merely represent an extension of the application of the rules for hedging transactions? The second implication appears more likely. It is doubtful that in such previously discussed cases as Olson, Butcher, or Azur Nut Co., that the Circle K case would be of much help in claiming ordinary asset treatment. However, though the Supreme Court reduced Corn Products down to a beachhead, the Court of Claims has slightly widened that beachhead. Interested parties should stay tuned for future developments.

Gary L. Maydew, PhD, CPA, is an Associate Professor of Accounting at Iowa State University. He is the author of a book on agribusiness accounting and taxation and has a forthcoming book on tax planning for small businesses. Dr. Maydew has published articles in Taxes, The CPA Journal, The National Public Accountant, and other journals, and regularly conducts seminars on taxation and accountancy topics.