One of the most fundamental distinctions in the field of tax is the distinction between ordinary income and capital gain. In general, ordinary income is any income derived from the course of typical business activities, while capital gains results from investment activities. If you generate income from a business you own, or if you earn money in the form of wages as an employee, then this would be considered ordinary income; if you sell a “capital asset,” on the other hand, such as a bond or other investment instrument, then this income would be treated as capital gain. In many cases, if not most, the distinction between these two types of income is pretty straightforward and there’s not too much room for debate as to the proper classification. However, in some instances, there can be uncertainty as to whether income should fall into one or the other category.
The issue of whether income should be classified as ordinary income or capital gains is a very important one because these classifications affect tax treatment. If you sell a capital asset – let’s say, stock in a corporation – then you’ll be taxed at a rate which uniquely applies to capital gain rather than ordinary income. In this article, we will discuss the contours of capital gain treatment by examining how such treatment can be affected by the manner which an asset is held; we will then look at the so-called “7 pillars” of capital gains treatment which provide us with guidelines for determining treatment in a given case.
Holding Affects Capital Gains Tax Treatment
As mentioned, capital gains treatment will follow whenever an individual or business entity sells a capital asset. The determination of whether a given piece of property qualifies as a capital asset is not simply based on identity; the particular manner in which the property is held is also relevant. For instance, stock in a corporation is typically a capital asset, but that is because stock is usually held as an investment. When most people buy stock, they buy it with the intention to hold it as an investment which will eventually yield them a high return. But, suppose that someone were to receive stock as wages – would the stock be considered a capital asset in this scenario? In such a case, the stock would actually be taxed initially as ordinary income because it was received as compensation for work performed in the course of employment.
Likewise, real estate is typically held as an investment, and real estate investors are often saddled with large capital gains tax liabilities when they ultimately sell their investment property. But, again, a critical factor in determining capital gains treatment is the way in which the property is held, and so if someone buys a piece of real estate and then treats the property as their primary residence, they will not receive capital gains treatment if they decide to cash out. The key point to take away is that capital gains treatment is determined by your actions rather than the identity of the property you own.
Byram v. United States & the 7 Capital Gains Pillars
In some cases, there can be disputes as to the proper classification of a given source of income. Fortunately, case law provides some level of guidance for those who may be uncertain about how to categorize their income. The case of Byram v. United States (1983) is a well-known piece of litigation which helped to clarify the distinction between ordinary income and capital gains. In making its decision, the court referenced the 7 pillars of capital gains treatment – that is, 7 factors to consider when analyzing a given dispute.
In this case, Byram sold a total of 22 pieces of real estate over a two-year period between 1971 and 1973. During that time, he did not keep a business office, did not actively advertise his real estate for sale, did not engage a broker, he did not subdivide his real estate, and all of the transactions were initiated by the buyers. Given the time scale involved, as well as his profits – he profited approximately $3.4 million from all of the sales combined – the IRS had reason to argue that Byram was actually engaged in a formal business and that his income should therefore be classified as ordinary income.
In its analysis, the court identified the 7 pillars of capital gains treatment as follows: (1) the basic purpose of acquiring the assets and the duration of ownership, (2) how much effort was put into selling the assets, (3) the number, extent, magnitude and overall continuity of the sales, (4) time and energy devoted to developing the assets and advertising to increase volume of sales, (5) whether the taxpayer used a business office when making the sales, (6) the level of supervision exercised by the taxpayer over any representative involved with selling the assets, and (7) the total amount of time and energy devoted to making the sales.
The court – in this case, the Court of Appeals for the Fifth Circuit – affirmed the trail court ruling in favor of Byram. Byram’s behavior throughout the years of 1971 – 1973 supported the determination that his income should be classified as capital gains rather than ordinary income. Even though he sold the real estate over a lengthy period, not enough of his actions could be used to support the idea that he had been engaged in a formal business.
Ordinary income and capital gains are two fundamental concepts in the field of tax. Again, determining which category your income falls into is very important, because these categories impact your tax liability. As we’ve seen, there are numerous factors which courts will look at when making a decision as to which is the proper classification in any given case. If you have an issue relating to capital gains treatment, or any other tax issue, don’t hesitate to reach out to the firm of Mackay, Caswell & Callahan, P.C. and we will assist you with your case!