Question

Cassius Clay operates a bituminous coal home heating and delivery service in Dauphin and Center counties. He must have a supply of bituminous coal on hand so customers may get the coal they need to heat their homes. As a convenience to his customers, and to prevent high bills over the winter and low bills in the summer, he allows them to buy coal in advance at set prices and to pay for the coal ratably over a calendar year. To ensure himself a steady, reliable, and affordable supply of coal and to protect against price fluctuations, Cassius Clay enters into certain futures contracts to buy coal at a future date and at a set price. Clay clearly indicates beforehand that the futures contract in which he enters to buy coal is simply to secure a supply of coal and to protect him from losses on the futures contracts with his customers to sell coal, and that he does not intend to profit from the contract itself. Assume that Cassius Clay realizes a loss on the futures contract in which he entered to buy coal. That is, the price per his contract to buy coal is higher than the actual spot market price of coal the day he acquires a new supply of coal. How should Cassius Clay classify the loss—as ordinary or as capital? Be sure to demonstrate your research skills in writing a memo to the file. You must cite the relevant code section(s) (including section 1221) and at least two (2) Supreme Court cases (hint: the two key cases are dated 1955 and 1988). You must also address the general principle of classifying assets—as capital or as operating—and the exceptions thereto.

Answer 1

26 U.S. Code § 1221 - Capital asset

(a)In general For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

(1) stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

(2) property, used in his trade or business, of a character which is subject to the allowance for depreciation provided in section 167, or real property used in his trade or business;

(3)a patent, invention, model or design (whether or not patented), a secret formula or process, a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by—(A) a taxpayer whose personal efforts created such property,

(B) in the case of a letter, memorandum, or similar property, a taxpayer for whom such property was prepared or produced, or

(C) a taxpayer in whose hands the basis of such property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such property in the hands of a taxpayer described in subparagraph (A) or (B);

(4) accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of property described in paragraph (1);

(5) a publication of the United States Government (including the Congressional Record) which is received from the United States Government or any agency thereof, other than by purchase at the price at which it is offered for sale to the public, and which is held by—

(A) a taxpayer who so received such publication, or

(B) a taxpayer in whose hands the basis of such publication is determined, for purposes of determining gain from a sale or exchange, in whole or in part by reference to the basis of such publication in the hands of a taxpayer described in subparagraph (A);

(6) any commodities derivative financial instrument held by a commodities derivatives dealer, unless—   (A) it is established to the satisfaction of the Secretary that such instrument has no connection to the activities of such dealer as a dealer, and

(B) such instrument is clearly identified in such dealer’s records as being described in subparagraph (A) before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe);

(7) any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe); or

(8) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer.

To determine whether the instrument is a “capital asset” or an “ordinary asset” in the hands of the taxpayer. IRC § 1221 defines “capital assets” by exclusion – unless an asset falls within one of eight enumerated exceptions, it is viewed as a capital asset. Exceptions to capital asset treatment relevant to taxpayers transacting in derivative instruments include the exceptions for (1) hedging transactions and (2) “commodities derivative financial instruments” held by a “commodities derivatives dealer”.

, a “commodities derivatives dealer” is a person which regularly offers to enter into, assume, offset, assign or terminate positions in commodities derivative financial instruments with customers in the ordinary course of a trade or business.

"Cassius Clay enters into certain futures contracts to buy coal" Thus he's a commodities derivatives dealer and this transactions will be in nature of Ordinary business.

Case Laws:-

Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955)

The Corn Products case involved discussion of whether income arising from the sale of corn futures by a company that refined corn into other forms and food products were entitled to capital gains treatment. The company bought corn futures to protect their future corn supply and pricing and would sell the futures if it had excess inventory corn for its processes. As the corn futures were essentially inventory, they were classified as such property which would “properly be included in the inventory of the taxpayer … in the ordinary course of his trade or business.” I.R.C. § 1221(a)(1).

Since the time of Corn Products, IRC §1221(a)(7) was added which specifically excludes from the definition of capital asset "any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or other such time as the Secretary may by regulations prescribe)."^[

This is essentially a codification of the result in Corn Products and removes the necessity of classifying hedging transactions as "inventory" under IRC § 1221(a)(1).

Arkansas Best Corporation v. Commissioner, 485 U.S. 212 (1988)

Arkansas Best, a diversified holding company acquired a large percentage of the stock of the National Bank of Commerce in Dallas, Texas. When the real estate market in Dallas faltered, Arkansas Best sold a large portion of its stake in the Bank at a loss. Arkansas Best claimed a deduction for an ordinary loss of nearly $10 million from the sale. The Commissioner of the Internal Revenue Servicedisallowed the deduction, finding that it was a capital, not ordinary loss.

Issue

Was the stock properly a capital asset as defined by I.R.C. § 1221? Should the Court read § 1221 broadly as it had in Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955)?

Holding

The Eighth Circuit reversed the Tax Court’s determination that the loss was an ordinary loss since the Bank stock fell within the general definition of “capital asset” in I.R.C. § 1221 and did not fall within any of the statutory exceptions in the section.^[3] A taxpayer’s motivation in purchasing an asset is irrelevant to its classification.

Reasoning

• The broad definition of the term “capital asset” explicitly makes irrelevant any consideration of the property’s connection with the taxpayer’s business. The motive behind the purchase of the asset is not mentioned as a factor in § 1221.
• Congress does not direct the Court to read § 1221 liberally. Congress intended the specific exceptions explicitly contained in § 1221.
• The holding in Corn Products is that hedging transactions that are an integral part of a business’ inventory-purchase system fall within the inventory exclusion of § 1221. This ruling does not apply to the facts of this case.
• The capital stock held by Arkansas Best falls within the broad definition of a “capital asset” in § 1221 and is outside the classes of property excluded from capital-asset status.