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AOD 2019-03: Non-Acquiescence to Tax Court Ruling Regarding the Tax Treatment of a Franchise Transfer – By SANDRA BROWN and GARY MARKARIAN

On October 11, 2019, the IRS announced its non-acquiescence with the United States Tax Court’s holding in GreenTeam Materials Recovery Facility PN. [3]  In this case, the court held that (1) the sales of businesses which had local government service contracts were considered franchises pursuant to I.R.C. §1253(a); and (2) the sale of franchises were allowed capital-gains treatment, under I.R.C. §1253(d), if the taxpayers did not retain any interest in the transferred property.

I.R.C. § 1253

I.R.C. § 1253(a) states that “a transfer of a franchise, trademark, or trade name shall not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest with respect to the transferred property.”

A “’franchise’ includes an agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area.”[4]

Examples of “significant power, right, or continuing interest” include, but are not limited to: (a) the right to disapprove any assignment of such interest; (b) the right to terminate at will; (c) the right to prescribe the standards of quality of products used or sold, or of services furnished, and of the equipment and facilities used to promote such products or services; (d) the right to require that the transferee sell or advertise only products or services of the transferor; (e) the right to require that the transferee purchase substantially all of his supplies and equipment from the transferor; and (f) the right to payments contingent on the productivity, use, or disposition of the subject matter of the interest transferred, if such payments constitute a substantial element under the transfer agreement.”[5]

With regards to other payments, “any amount paid or incurred on account of a transfer, sale, or other disposition of a franchise, trademark, or trade name to which paragraph [(d)](1) does not apply shall be treated as an amount chargeable to capital account.”[6]

GreenTeam Case

Facts

Beginning in 1991, the Greenteam partnerships had contracts with different cities to collect residential and commercial waste, provide carts and bins, and sort recyclables.[7] In 2002, they were approached by Chaparral Group LLC, a consulting group for the waste industry, interested in purchasing the partnerships.[8] In 2003, Greenwaste of Tehama, a California partnership, sold its waste-collection business for $8,000,000.[9] Two related partnerships, Greenteam of San Jose and Greenteam Materials Recovery Facility also sold assets of their businesses for $38,000,000.[10] The sales for all three partnerships included tangible and intangible assets.[11] The purchase price was allocated between the covenant not to compete, tangible assets, buildings, and land.[12] On their 2003 tax returns, the Greenwaste partnerships reported the covenant not to compete and tangible assets according to the allocation in the contract.[13] The remaining sums were allocated towards good-will and going concern.[14]

In 2009, the IRS audited the returns under TEFRA, and recharacterized the majority of good-will and going concern as ordinary income.[15] The partnerships argued the contracts fell under I.R.C. § 1253 while the Commissioner believed the section did not apply because Greenteam partnerships did not keep any interest in the contracts.[16] As such,  the Commissioner asserted that the court should decide  the contract was a capital asset by looking at I.R.C. § 1221.[17]

Analysis

In determining whether the Greenteam partnerships were franchises, the court followed the reasoning in Tele-Commc’ns, Inc. v. Commissioner.[18] In Tele-Commc’ns, the court determined that there is a franchise if there is an agreement in which one party receives the right to provide services, within a defined area.[19] The issue in Tele-Commc’ns was whether I.R.C. § 1253 could apply if the franchise was granted by a local government.  In that case, the court found that I.R.C. § 1253 could apply to both public and private franchises.[20]

The Commissioner in Greenteam argued that the term “franchise” in the California waste and recycling industry means only a contract that continues until it’s terminated.  However, when a contract between a company and a local government is to provide specific services for a limited time, it is instead a “municipal contract.” rather than a “franchise”. [21] The Greenteam Court rejected this argument stating that the definition set forth by the federal tax statutes, not California’s industry definition, controlled.[22]

The court also had to determine whether the Greenteam partnerships held any “significant power, right, or continuing interest” in the franchises.[23] If they did, the sale would be ordinary.[24] The Greenteam partnerships did not keep any interest in the franchises and did not receive contingent payments.[25] As a result, they weren’t ineligible for capital-gains treatment.[26] The Court notes the issue here is that although I.R.C. 1253(a) states a transaction that does not get capital gains treatment, it does not specifically state what does.[27]

The Commissioner further argued that the lack of specificity means I.R.C. § 1253 is inapplicable by its own terms, and thus the transaction should be taxed as ordinary income.[28] The court however looked at I.R.C. § 1253(d)(2) and concluded the subsection implied that “the sale of a franchise leads to capital gains unless the transaction is specifically knocked out of section 1253 by section 1253(a).”[29] The court also pointed to caselaw which affirmed this analysis.[30]

Court’s Conclusion

In conclusion, the Greenteam Court found I.R.C. § 1253 applies because the taxpayers kept no significant interest in the contracts they sold and because caselaw states that the taxpayers are entitled to capital-gains treatment on their profits from the sales.[31]

IRS Non-Acquiescence

It is important to understand the significance of the IRS’s non-acquiescence with this decision.  A non-acquiescence means that, while the IRS has decided not to  appeal the court’s ruling in this instance, and therefore that taxpayer will be afforded the capital-gains tax treatment, other taxpayers may not be so fortunate, as the IRS has provided notice that it disagrees with the court’s holding. Generally, where the IRS has provided notice of such non-acquiescence, then taxpayers may anticipate that in future administrative or judicial proceedings the IRS will, absent binding appellate precedence or a change in IRS position, will continue to challenge such holding.

Therefore, while taxpayers in situations similar to the Greenteam taxpayers may take some comfort in the Tax Court’s ruling, such taxpayers should also anticipate, and plan for, opposition from the IRS.

[1] Sandra R. Brown is a principal at Hochman Salkin, Toscher Perez P.C., and specializes in representing individuals and organizations who are involved in criminal tax investigations, including related grand jury matters, court litigation and appeals, as well as representing and advising taxpayers involved in complex and sophisticated civil tax controversies, including representing and advising taxpayers in sensitive-issue audits and administrative appeals, as well as civil litigation in federal, state and tax court.  Prior to joining the firm, Ms. Brown served as the Acting United States Attorney, the First Assistant United States Attorney and the Chief of the Tax Division of the Office of the U.S. Attorney (C.D. Cal).

[2] Gary Markarian is a law clerk at Hochman Salkin Toscher Perez P.C., and a recent graduate of the joint JD/LL.M. Taxation program at Loyola Law School, Los Angeles. Mr. Markarian’s prior tax experience includes externships with the Tax Division of the U.S. Attorney’s Office (CDCA), the Office of Chief Counsel, IRS (LB&I), Los Angeles, and Loyola Law School’s Sales and Use Tax Clinic.

[3] GreenTeam Materials Recovery Facility PN, GreenWaste Recovery, Inc., Tax Matters Partner, et al. v. Commissioner, T.C. Memo. 2017-122 (“GreenTeam”)

[4] I.R.C. § 1253(b)(1)

[5] I.R.C. § 1253(b)(2)

[6] I.R.C. § 1253(d)(2)

[7] Id. at *3-*6

[8] Id. at *6

[9] GreenTeam T.C. Memo 2017-122 at *2

[10] Id.

[11] Id.

[12] Id. at *7

[13] Id. at *7-8

[14] Id.

[15] Id. at *9-10

[16] Id. at *11

[17] Id.

[18] Tele-Commc’ns, Inc. v. Commissioner, 12 F.3d 1005, 1006 (10th Cir. 1993), aff’g 95. T.C. 495 (1990)

[19] Tele-Commc’ns, Inc. v. Commissioner, 95 T.C. at 509

[20] Id. at 511

[21] Id. at *14-15

[22] Id.

[29] Id. at *16-17

[30] Id. at *17

[31] Id. at *18

 

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