In Hurford Investments No. 2, Ltd. v. Commissioner of Internal Revenue (order dated April 17, 2017), the Tax Court granted a taxpayer's motion for summary judgment, ruling that income that the taxpayer (a partnership) received upon the termination of a "phantom stock" account (i.e., a non-stock asset tied to the value of a company's stock) was long-term capital gain. In so ruling, the court applied Section 1234A, notwithstanding the Fifth Circuit's reversal of the Tax Court decision in Pilgrim's Pride Corp. v. Commissioner, 779 F.3d 311 (5th Cir. 2015), rev'g 141 T.C. 533 (2013). As an interim order on a motion, the court's ruling cannot be cited as precedent.

Facts

The facts in this case are complex, but for present purposes may be simplified as follows. Mr. Hurford received "phantom stock" from the Hunt Oil Company as compensation related to his work with that company. This phantom stock was not actual stock and carried no ownership interest in Hunt Oil, but was a form of deferred compensation that was tied to the value of the Hunt Oil common stock.

Upon the death of Mr. Hurford in 1999, the phantom stock passed first to his wife, who in turn gave the phantom stock to a partnership, Hurford Investments No. 2, LLC (HI-2). In 2006, Hunt Oil distributed almost $13 million to HI-2 in satisfaction of the phantom stock arrangement. The court determined that HI-2's basis in the phantom stock was $9.6 million, so the remaining issues were (1) whether the phantom stock was a capital asset in the hands of HI-2 and (2) whether the gain on the satisfaction of the phantom stock was capital gain under Section 1234A.

The Capital Asset Issue

The Tax Court agreed with HI-2 that the phantom stock was a capital asset in its hands under Section 1221. Under Section 1221, generally any property not specifically excluded is treated as a capital asset — and the phantom stock, in the hands of HI-2, fit none of the exceptions. The IRS argued that the common law substitute-for-ordinary-income exception applied, which is generally applied to lottery winnings. However, the court distinguished the phantom stock in HI-2's hands from lottery winnings, noting the phantom stock could decrease in value. While the phantom stock was originally a source of compensation income to Mr. Hurford, that phase of the asset's existence terminated upon the death of Mr. Hurford and his wife. Accordingly, with no applicable exception to Section 1221, the court held the phantom stock was a capital asset.

Section 1234A

The IRS argued that, under Section 1222, even if the phantom stock was a capital asset, a sale or exchange of the asset must occur for capital gains rates to apply. Relying on case law, the IRS argued that HI-2 never sold or exchanged the asset for compensation — rather it just received its distribution under the terms of the phantom stock agreement. However, HI-2 argued that the case law in question was superseded by Section 1234A.

Under Section 1234A: "Gain or loss attributable to the cancellation, lapse, expiration, or other termination of — (1) a right or obligation … with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer … shall be treated as gain or loss from the sale of a capital asset." HI-2 argued that when Hunt Oil liquidated the phantom stock plan in 2006 and distributed the value of the account to HI-2, HI-2's interest was subject to a "cancellation, lapse, expiration, or other termination" within the meaning of Section 1234A. Accordingly, capital gains treatment applies.

An important consideration in determining whether Section 1234A applies in this situation is the Fifth Circuit Court of Appeals decision in Pilgrim's Pride. (See Tax Alert 2015-445 for a discussion of Pilgrim's Pride.) In Pilgrim's Pride, the Fifth Circuit, reversing the Tax Court, held that Section 1234A did not apply to the abandonment of securities, so the taxpayer was able to obtain ordinary loss treatment. The Tax Court had held that such abandonment would be a capital loss by constituting a cancellation, lapse, expiration, or other termination under Section 1234A. However, the Fifth Circuit interpreted Section 1234A to apply only to the termination of rights or obligations with respect to a capital asset (e.g., derivative or contractual rights), not to the termination of ownership of the capital asset itself.

In HI-2's case, the critical question was whether the phantom stock was merely an asset whose ownership had been terminated or a right with respect to another asset. The Tax Court concluded that Hunt Oil's liquidation of the phantom stock was a termination of a right, not just of ownership. To support this conclusion, it stated only that HI-2 lost its right to liquidate the phantom stock account at the time of its choosing. Accordingly, the court determined that the liquidation was the sale or exchange of a capital asset under Section 1234A and, therefore, capital gains treatment applies. Surprisingly, the court did not base its decision at all on the fact that the phantom stock was a derivative, i.e., a right whose value depended on the value of Hunt Oil stock but was not actual stock.

Implications

While the Tax Court's decision that Section 1234A applies appears correct, the analysis, if taken literally, could be read as making a nullity of the Fifth Circuit's holding in Pilgrim's Pride. It is unlikely, however, that the case will be read so broadly by other courts or even by the Tax Court in subsequent cases. More likely, the case, which is non-precedential, will be limited to essentially the same facts as in the case — redemption of a phantom stock right that is a capital asset in the hands of the taxpayer gives rise to capital gain or loss.

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