Eleventh Circuit Protects the Sale of a Litigation Interest from High Rates of Taxation

In Long v. Commissioner of IRS, No. 14-10288 (Nov. 20, 2014), the Eleventh Circuit held that a party’s sale of their position in a lawsuit constitutes a “capital asset”, thus may be taxed as a capital gain, instead of ordinary income.  The court also held that an agreement selling an interest in a joint venture which replaces a loan agreement is treated as a renegotiation of repayment terms and thus does not qualify as a deductible business expense.

Long, a sole proprietor, created Las Olas Tower Company (LOTC) for the purpose of developing a luxury high-rise condominium called the Las Olas Tower on property owned by the Las Olas Riverside Hotel (LORH).  In order to fund the development, Long entered into a loan agreement with another company, Steelervest.  Long had previously formed Alhambra Joint Ventures (AJV), with Steelervest for the development of a different condominium.  In late 2001, Long sold his interest in AJV to Steelervest where Steelervest agreed to forgive the loans to LOTC. Long also agreed to pay Steelervest $600,000 in the event Long sold his interest in the Las Olas Tower project.  In 2002, Long, acting as LOTC, entered into an agreement with LORH for the sale of the property on which the Las Olas Tower was to be built.  LORH unilaterally terminated the contract, leading LOTC to file suit seeking specific performance of the sales agreement.  The trial court entered judgment in favor of LOTC, from which LORH appealed.  On September 13, 2006, during the appeals process, Long sold his position as plaintiff in the litigation for $5,750,000.  Despite an amended agreement to the contrary. Steelervest agreed to receive $600,000 and release all rights to pursue collection from Long/LOTC.

Long claimed the $5.75 million received for the sale of his position in the lawsuit as long term capital gains on his 2006 taxes.  He also claimed the $600,000 payment to Steelervest was a deductible business expense, making his 2006 taxable income $0.  In 2010, the IRS served Long with a notice of deficiency, claiming the $5.75 million was ordinary income and the $600,000 payment to Steelervest was a loan repayment, which is not deductible.  The IRS also claimed Long claimed over $230,000 in unaccounted legal fees as deductible legal expenses.  Long attempted to provide a letter from his attorney as evidence, but this was rejected by the court, leading Long to concede the issue of unaccounted legal fees.

To determine whether the $5.75 million Long received for the sale of his position in the law suit with LORH, the court narrowly construed the term “capital asset”.  The court stated that the litigation interest was a contractual right, not a sale of land as the tax court held, it qualified as a capital asset.  The court next had to determine whether Long held this right “primarily for sale to customers in the ordinary course of his trade or business”.  If that were the case, it would be considered a substitute for ordinary income, not a capital gain.  Here, the court held that Long obtained this right for the purpose of developing the tower, not to sell the right to develop the tower.  Public policy also favors allocating this as a capital gain and protecting from higher taxation as it encourages the transfer of property and benefits economic development.  This amount further constitutes a long term capital gain because it was held by long for over one year as determined from the time he entered in to the agreement with LORH.

In claiming a deductible business expense, the taxpayer has the burden of proving that the expense qualifies a deductible expense, Long failed to overcome this burden in this case by failing to identify any provision of the tax code qualifying this expense as deductible expense.  Instead, the court looked to the nature and character of the $600,000 paid to Steelervest and determined that the agreement for the payment was a renegotiation of loan repayment terms, not a “profit participation” plan as alleged by Long.

The court briefly discussed the issue of the unaccounted for legal expenses, finding that Long had not sufficiently offered evidence to demonstrate his entitlement to the deduction.  In order to uphold the tax court’s findings, the court stated that a taxpayer has the burden of presenting sufficient evidence to prove a deducible expense.  Long did not overcome this burden.

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