The state income tax credit is capital



The Tax Court ruled that the sale by a taxpayer of a state income tax credit resulted in a capital gain, not ordinary income, since the payments received from the sale did not substitute not to ordinary income.

Fixed assets include all assets except those listed in eight categories in IRC § 1221 (a). Current non-fixed assets are inventories, accounts and notes receivable, depreciable property and land used in a trade or business, and supplies. Certain copyrights, US government publications, commodity derivatives, and hedging transactions are also excluded from capital assets. In addition to the eight statutory exclusions, the courts have ruled that the right to receive future ordinary income is not capital.

In 2004, Colorado residents George and Georgetta Tempel made a charitable donation of a qualified conservation easement and thus qualified under Colorado law for $ 260,000 in income tax credits for the state conservation donations. The credits made Tempels eligible for a limited Colorado state income tax refund. The couple were also allowed under Colorado law to carry over unused credits for up to 20 years, or they could transfer the unused credits to certain other taxpayers. In December 2004, the Tempels sold $ 110,000 in tax credits, receiving net proceeds of $ 82,500. In their joint federal return, after allocating a base of $ 4,897 (a portion of the professional fees incurred to make the donation) to tax credits, the Tempels reported a short-term capital gain of $ 77,603 in their tax credits. 2004 statement. The IRS issued a deficit notice for 2004 and 2005 reclassifying all proceeds to ordinary income and assigning a zero base to credits. Taxpayers have asked the Tax Court for relief. In a counterclaim to the government’s summary judgment motion, the Tempels argued that the gain should be a long-term capital gain and that part of the cost of the land could be allocated to state credits as a basis.

The IRS admitted that income tax credits did not fall under any of the eight statutory exceptions, but instead argued that there had been a sale of contractual rights that should be analyzed using the test to six factors of
Gladden v. Commissioner
(112 TC 209). The court ruled on
Rejoice factors were inapplicable in this case because the tax credits granted by the government are not contractual rights.

The IRS further argued that the Tempels had the equivalent of economic income when they sold their state tax credits because their future federal tax payable was lower due to future itemized deductions plus high for state income taxes. The court ruled that a lower tax is not an increase in wealth and cannot be income. In addition, the receipt of the credits by the Tempels was not a right to income and, therefore, they did not sell a right to earned income or to earn income. Thus, the product could not substitute for the right to receive future ordinary income, according to the court.

The court agreed with the IRS, however, that Tempels’ base in credits was zero. She felt that none of the expenses related to the donation should be used as the basis for the credits, since taxpayers did not acquire them by purchase but received them in accordance with a state tax law. In addition, no basis of their land could be attributed to the credits that were sold, as the credits did not constitute a right of ownership over the land they owned. For similar reasons, the court also rejected the taxpayers’ argument that their period of holding the land on which the conservation easement was based should be carried over to the appropriations and therefore concluded that their gain was short-term.

George H. and Georgetta Tempel v. Commissioner
, 136 TC no. 15

Charles J. Reichert, CPA, professor of accounting, University of Wisconsin-Superior.

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