The Tax Court has concluded that three individuals incorrectly characterized ordinary partnership income from the sale of real estate as long-term capital gain.
In this case, Concinnity, LLC, which elected to be taxed as a partnership, was organized by Cordell Pool, Justin Buchanan and Thomas Kallenbach. These three individuals also incorporated Elk Grove Development Company (Cordell D. Pool, et. al. v. Commissioner, TC Memo, 2014-3, Jan. 8, 2014).
Concinnity purchased 300 acres of undeveloped land. At the time of purchase, the land was already divided into four sections (phases 1-4). This property later became the Elk Grove Planned Unit Development (PUD).
Concinnity entered into an agreement that gave Elk Grove Development Company the exclusive right to purchase phases 1-3, consisting of 300 lots. This agreement required Elk Grove to complete all infrastructure improvements necessary to obtain the final plat of each phase of the PUD. Concinnity also entered into an improvements agreement with the county agreeing that it, as subdivider, would pay for the improvements to the land in phase 1.
On its income tax returns, Concinnity consistently reported that it sold land resulting in long-term capital gain. The three partners reported their shares of the partnership’s gain from the sale of real property as long-term capital gain.
The IRS claimed that Concinnity’s land sales produced ordinary income. The three partners claimed that the sale produced capital gain because the land was held for investment.
The Tax Court agreed with the IRS that the proceeds of the land sale should be reported as ordinary income. In reaching its conclusion, the court reviewed several factors:
- Nature of acquisition. The Tax Court found that the record did not clearly show Concinnity’s purpose in acquiring the land. However, the evidence suggested that it acquired it for development and sale. While the court noted that the operative inquiry was the purpose for which the property was held – not the purpose of its acquisition – the court determined that there was no evidence showing that Concinnity’s intentions changed during the course of holding the property. The court concluded that the taxpayers failed to show that the property was held for investment purposes.
- Frequency and continuity of sales. The court observed that frequent and substantial sales of real property more likely indicate sales in the ordinary course of business, whereas infrequent sales for significant profits are more indicative of real property held as an investment. In this case, the record was not clear as to the frequency and substantiality of Concinnity’s sales. The court found that the record was insufficient to establish Concinnity’s role in the business or overall level of activity with regard to the property. In the end, the court concluded that the taxpayers failed to show that their sales were not frequent and substantial.
- Nature and extent of business. The IRS argued that the only documents in the record indicated that Concinnity brokered the deals, found additional investors for the development project, secured water and wastewater systems, and guaranteed performance on the improvements agreement. While it did not wholly accept the IRS contentions, the court found that there was evidence that Concinnity obligated itself to make certain water and wastewater improvements to the PUD and paid for those improvements. The court reasoned that this level of activity was more akin to a real estate developer’s involvement in a development project than to an investor’s increasing the value of his holdings.
- Activity of seller about the property. The record was unclear as to whether Concinnity sold lots only to Elk Grove or also sold lots to others. The court found that the taxpayers failed to show that Concinnity did not spend large portions of its time actively participating in the sales of the PUD lots. The court said that this factor weighed in favor of the IRS.
- Extent and substantiality of the transaction. While the IRS argued that Elk Grove should be ignored as an entity because the taxpayers incorporated it principally to evade or defeat tax, the court found that the “identical ownership” of Concinnity and Elk Grove did not necessarily mean that Elk Grove should be disregarded. However, the court concluded that the taxpayers failed to produce sufficient evidence demonstrating that they engaged in a bona fide, arm’s-length transaction.