Read § 1221(a). Notice the structure of the definition, i.e., all property except ... Do not the first two lines of this section imply that “capital asset” is a broad concept? Is there a common theme to the exceptions – at least to some of them?
In Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), taxpayer was a manufacturer of products made from corn. Its profitability was vulnerable to price increases for corn. In order to protect itself against price increases and potential shortages, taxpayer “took a long position in corn futures 1” at harvest time when prices were “favorable.” Id. at 48. If no shortage appeared when taxpayer needed corn, it would take delivery on as much corn as it needed and sell the unneeded futures. However, if there were a shortage, it would sell the futures only as it was able to purchase corn on the spot market. In this manner, taxpayer protected itself against seasonal increases in the price of corn. Taxpayer was concerned only with losses resulting from price increases, not from price decreases. It evidently purchased futures to cover (much) more than the corn it would actually need. Seeid. at 49 n.5. Hence, taxpayer sold corn futures at a profit or loss. Over a period when its gains far exceeded its losses, taxpayer treated these sales as sales of capital assets. This would subject its gains to tax rates lower than the tax rate on its ordinary income. At the time, the Code did not expressly exclude transactions of this nature from property constituting a capital asset. The Commissioner argued that taxpayer’s transactions in corn futures were hedges that protected taxpayer from price increases of a commodity that was “‘integral to its manufacturing business[.]’” Id. at 51. The Tax Court agreed with the Commissioner as did the United States Court of Appeals for the Second Circuit. The United States Supreme Court affirmed. The Court said:
Admittedly, [taxpayer’s] corn futures do not come within the literal language of the exclusions set out in that section. They were not stock in trade, actual inventory, property held for sale to customers or depreciable property used in a trade or business. But the capital-asset provision ... must not be so broadly applied as to defeat rather than further the purpose of Congress. [citation omitted]. Congress intended that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss. The [Code’s] preferential treatment [of capital gains] applies to transactions in property which are not the normal source of business income. It was intended ‘to relieve the taxpayer from * * * excessive tax burdens on gains resulting from a conversion of capital investments, and to remove the deterrent effect of those burdens on such conversions.’ [citation omitted]. Since this section is an exception from the normal tax requirements of the Internal Revenue Code, the definition of a capital asset must be narrowly applied and its exclusions interpreted broadly. This is necessary to effectuate the basic congressional purpose.
Id. at 51-52. Subsequent to this case, Congress amended § 1221 by adding what is now § 1221(a)(7). A “capital asset” does not include “any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into ...”
In other cases, taxpayers successfully argued that a futures transaction that proved profitable involved a “capital asset,” whereas a futures transaction that proved unprofitable was a hedge against price fluctuations in a commodity that was definitionally not a “capital asset.” Losses therefore could offset ordinary income. This “head-I-win-tails-you-lose” whipsaw of the Commissioner should have ended with the holding in Corn Products. The Commissioner won in Corn Products. Should the Commissioner be happy about that? Do you think that hedge transactions of the sort described in Corn Products more often produce profit or loss?
- The statutory embodiment of the Corn Products rule creates the presumption that a hedge is a capital asset transaction unless the taxpayer identifies it as an “ordinary income transaction” at the time taxpayer enters the transaction. How does this scheme prevent the whipsaw of the Commissioner?
Corn Products is also important for its statements concerning how to construe § 1221. While the structure of § 1221 implies that “capital asset” is a broad concept, i.e., “all property except ...”, the Court stated that the exceptions were to be construed broadly – thereby eroding the scope of the phrase “capital asset.” Furthermore, we might surmise that a major point of Corn Products is that a transaction that is a “surrogate” for a “non-capital” transaction is in fact a non-capital transaction.
In Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), taxpayer was a diversified holding company that purchased approximately 65% of the stock of a Dallas bank. The bank needed more capital and so over the course of five years, taxpayer tripled its investment in the bank without increasing its percentage interest. During that time, the financial health of the bank declined significantly. Taxpayer sold the bulk of its stock, retaining only a 14.7% interest. It claimed an ordinary loss on the sale of this stock, arguing that its ownership of the stock was for business purposes rather than investment purposes. The Commissioner argued that the loss was a capital loss. Taxpayer argued that Corn Products supported the position that property purchased with a business motive was not a capital asset. The Tax Court agreed with this analysis and applied it to the individual blocks of stock that taxpayer had purchased, evidently finding that the motivation for different purchases was different. The United States Court of Appeals for the Eighth Circuit reversed, finding that the bank stock was clearly a capital asset. The Supreme Court affirmed. The Court refused to define “capital asset” so as to exclude the entire class of assets purchased for a business purpose. “The broad definition of the term ‘capital asset’ explicitly makes irrelevant any consideration of the property’s connection with the taxpayer’s business ...” Id. at 217. The Court held that the list of exceptions to § 1221's broad definition of “capital asset” is exclusive. Id. at 217-18. The Court (perhaps) narrowed its approach to “capital asset” questions in Corn Products to a broad application of the inventory exception rather than a narrow reading of the phrase “property held by the taxpayer[.]” Id. at 220. The corn futures in Corn Products were surrogates for inventory.
- Thus, “capital asset” is indeed “all property” except for the items – broadly defined – specifically named in § 1221(a).
- Read § 1221(a)’s list of exceptions to “capital assets” again. Is (are) there a general theme(s) to these exceptions?
- Read again the excerpt from Corn Products, above.
- The phrase “capital asset” certainly includes personal use property. Thus if a taxpayer sells his/her personal automobile for a gain, the gain is subject to tax as capital gain.
Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Capital Asset Identification
Net capital gain: the point of mismatching NLTCG and NSTCL
It might appear that § 1222(11)’s definition of “net capital gain” requires some advantageous mismatching of income and losses with different characters. The opposite is true. We know that reductions in taxable income, whether by exclusion or deduction, “work” only as hard as taxpayer’s marginal bracket to reduce his/her tax liability. We learn momentarily that a taxpayer’s tax bracket on net capital gain is always less than his/her tax bracket on ordinary income. Since NSTCG does not figure into a taxpayer’s “net capital gain,” it is subject to tax at taxpayer’s marginal rate on ordinary income. However, NSTCL reduces income that would otherwise be taxed at a rate lower than taxpayer’s ordinary rate. Hence, such losses “work” no harder than taxpayer’s marginal rate on his/her “net capital gain” at reducing his/her tax liability – not as hard as taxpayer’s marginal rate on his/her ordinary income.
Mismatch of NSTCL and different types of LTCG
We shall momentarily see that different types of LTCG combine to make up net capital gain, and that these types are not all subject to the same tax rates to an individual taxpayer. NSTCL reduces first LTCG of the same type, e.g., collectible losses first offset collectible gains. Then in sequence, NSTCL reduces LTCG that would otherwise be subject to successively lower rates of tax, i.e., NSTCL first reduces “net capital gain” subject to a tax rate of 28%, then to a tax rate of 25%, and then to a tax rate of 20%, 15%, or 0%. See §§ 1(h)(4)(B)(ii), 1(h)(6)(A)(ii).