Payments Received for Cancellation of a Lease or Distributorship
Agreement
By James M. Kehl, CPA
Mister, Burton & Palmisano, PC, Hunt Valley, Md
It is fairly common for a landlord or a tenant to receive payments
in consideration for that party's allowing a lease to terminate before
its required expiration date. Similarly, distributors may receive
payments in exchange for cancellation of their distributorship
agreements. These payments are income to the party who receives the
payments. The question is whether these payments constitute ordinary
income or whether these payments could constitute capital gain. This
commentary will discuss these issues and the conditions necessary for
characterization of payments for cancellation of leases or
distributorship agreements as capital gain to the recipient of those
payments.
A landlord may receive payments from a tenant in exchange for the
landlord's cancellation of the landlord's rights to future rental
payments under the lease. These amounts are characterized as ordinary
income to the landlord. The reasoning for this treatment is that, in
order for income from a transaction to constitute capital gain or
loss, there must be a sale or exchange of a capital asset or of a
§1231 asset held for more than one year that is used in a
taxpayer's trade or business. The landlord is not considered as
transferring an asset to the tenant, despite the fact that the
landlord is relinquishing rights to future income. For this reason,
payments received by a landlord for termination of the landlord's
contractual rights to future rent payments are considered ordinary
income to the landlord.1
A lessee or tenant may receive capital gain treatment for payments
that the lessee receives in consideration for the lessee's or tenant's
agreement to an early termination of a lease under certain
circumstances. In order for a payment from a transaction to be
characterized as part of a capital gain or loss, there are two
conditions that must be fulfilled: (1) the payment must be from a sale
or exchange of (2) a capital asset or of a §1231 asset. Section
1241 states that payments received by a lessee for cancellation of a
lease are considered as amounts received in exchange for the lease,
and thus provides that the lessee satisfies the exchange requirement.
A “cancellation” is a termination of all of the tenant's
or the lessee's contractual rights with respect to the leased property
other than by expiration of the lease in accordance with its
terms.2 Payment for partial
cancellation of a lease may be characterized as a payment received in
exchange for a lease if the cancellation is with respect to a
severable economic unit, such as a portion of the property covered by
the lease or a reduction in the lease's unexpired
term.3 Payments received for lease
modifications are not recognized as amounts received for
cancellation.4 Thus payments
received by a lessee for a lease's renewal, settlement, compromise or
extension will not qualify for exchange treatment under
§1241.
Payments that are refunds of advance rental payments are not
considered as received in exchange for a lease and are thereby taxable
as ordinary income to the lessee.5
It has also been held that an amount received by a controlling
shareholder under an individual release and indemnity agreement from
two controlled corporations were not, under the facts of this case,
considered as cancellation payments under
§1241.6
A lessee who fails to satisfy the provisions of §1241 may
still obtain capital gain or loss and sale or exchange treatment if
the lessee is considered, under other principles of tax law, as
relinquishing a substantial property interest. For example, a lessee
of property that relinquished its rights under a restrictive covenant
that prohibited the landlord from renting any part of the leased
building to a competing variety store was considered as relinquishing
a substantial property right. As a result, this lessee was entitled to
capital gain treatment on the
transaction.7
After the exchange requirement is satisfied, the second requirement
for capital gain treatment is that the lease must be either a capital
asset or a §1231 asset held for more than one year in the hands
of the lessee. Generally, a lease of property with respect to a
taxpayer's trade or business will qualify for capital gain or loss
treatment.8 For example, an
apartment building owner paid a taxpayer's wife, children and attorney
an amount of money in exchange for the taxpayer's leasehold interest
in two apartments and also permitted the taxpayer to use an apartment
rent-free for three years. The fair rental value of the apartment
received and the amounts paid to the taxpayer's family and attorney
were considered amounts received for the taxpayer's leasehold
interests in the apartments and were considered payments for capital
assets.9 Similarly, payments
received by a lessee from a sublessee in exchange for the lessee's
release of its rights under the lease to the landlord were considered
as capital gains received from the sale of the
lease.10
Distributor Agreements
Section 1241 states that an amount received by a distributor of
goods for cancellation of a distributorship agreement is consider as
received in an exchange provided that the distributor has a
substantial capital investment in the assets of the distributorship.
An amount is considered as received in exchange for cancellation of a
distributor's agreement if it is for a termination of all of the
distributor's contractual rights with respect to the
distributorship.11 A good faith
payment received for partial cancellation of some of a distributor's
rights under a distributorship agreement is characterized as an amount
received for cancellation if the specific cancellation relates to a
severable economic unit, such as the unexpired term of the
distributorship agreement, distribution rights in one of several
products or distribution rights in one of several
areas.12 Section 1241 only applies
to distributorship agreements that are for marketing or for marketing
and servicing of goods.13 Section
1241 does not apply to distributorship agreements that are for selling
intangible property or for rendering personal
services.14 Examples of
distributorship agreements for selling intangible property or for
rendering services include agreements for establishing insurance
agencies or security
brokerages.15
An example of the application of these provisions concerns a
distributor of food products. T is a distributor of various food
products. T leases a warehouse including cold storage facilities and
owns a number of trucks. T obtains the exclusive rights to market and
distribute certain frozen food products of Company Y in state X. The
distribution is accomplished by the use of warehouse and trucks that
were acquired before T entered into the agreement, and entails no
additional capital. Payments received by T from Y upon the
cancellation of the agreement are treated as received in exchange for
the distributorship
agreement.16
In order to enjoy the benefits of the exchange provisions of
§1241, a distributor must have a substantial capital investment
in the distributorship. This substantial capital investment must be in
physical assets, such as fixed assets and
inventories.17 An investment in an
office merely for the performance of clerical operations is not
considered substantial.18 The
substantial assets or capital that is necessary for carrying on the
distributorship's operations must actually be acquired by the
distributor and actually utilized in carrying on the distributorship
prior to the cancellation of the distributorship
agreement.19
For example, assume that in the above example, T entered into an
exclusive distributorship agreement with Y under which T merely
solicited orders through a staff of salesmen, with the goods shipped
by Y directly to the purchasers. Payments received upon the
cancellation of that distributorship agreement are not treated as
received in exchange for the
agreement.20
Conclusion
Section 1241 is a provision that can assist a lessee or a
distributor in obtaining capital gain treatment on the cancellation of
a lease or the cancellation of a distributorship agreement.
Practitioners should be aware of this provision in the event that it
may apply to situations the practitioners may encounter.
For more information, in the Tax Management Portfolios, see
Holthouse, 593 T.M., Real Estate Leases, and Rothman, Brady,
Capps, and Herzog, 561 T.M., Capital Assets, and in Tax
Practice Series, see ¶1770, Miscellaneous Capital Gain v.
Ordinary Income Issues, and ¶1630, Sale or Exchange
Requirement.
1
See Holthouse, 593 T.M., Real Estate Leases.
2
Regs. §1.1241-1(b).
3
Id.
4
Id.
5
See Gray v. Comr.,642 F.2d 320 (9th Cir. 1981); Peerless Steel Equipment Co. v. Comr., 26 T.C.M. 880 (1967).
6
See S. Van Lede Est. v. Comr., 28 T.C.M. 1422 (1969).
7
See Ray v. Comr., 210 F.2d 390 (5th Cir. 1954).
8
See Rev. Rul. 72-85, 1972-1 C.B. 234; PLR 200045019.
9
Stotis v. Comr., 72 T.C.M. 704 (1996).
10
Metropolitan Building Co. v. Comr., 282 F.2d 592 (9th Cir. 1960).
11
Regs. §1.1241-1(b).
12
Regs. §1.1241-1(b).
13
Regs. §1.1241-1(c).
14
Id.
15
Id.
16
Regs. §1.1241-1(c), Ex. (1).
17
Id.
18
Id.
19
Id.
20
Regs. §1.1241-1(c), Ex. (2).
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