United States v. Winthrop & the Test for Ordinary Income

Investment Property Real Estate Land Capital Gain

Investment Property

In our earlier article about the case of Byram v. United States (1983), we introduced the 7 pillars of capital gain treatment and discussed the recurring issue of distinguishing business sales from investment sales. In Byram, the court found the profits of multiple real estate transactions to be capital gains due to the peculiar facts which surrounded the transactions. In this article, we will discuss the specifics of an earlier case – United States v. Winthrop (1969) – in which the court rejected the capital gain classification and ruled that certain transactions were sales made in the ordinary course of business.

It is important that our readers have an understanding which is as clear as possible of what constitutes a capital gain so that they can avoid any unpleasant surprises. The facts of United States v. Winthrop contribute toward this understanding.

The case of United States v. Winthrop will also give readers a sense of the unpredictability in judicial reasoning. Prior to being heard by the Fifth Circuit Court of Appeals, the facts of this case were found to support a capital gain classification at the trial court; the Fifth Circuit actually had to overturn this finding to reach its conclusion. And given that there was no dispute between the trial court and appellate court over any matter of fact in the case, and that there were multiple potentially compelling cases cited by Winthrop, it follows that the outcome of even a strongly backed case cannot be predicted with mathematical certainty.

Facts

Over the course of a number of years, Mr. Winthrop (respondent in appellate case) inherited several pieces of real estate. Collectively, these pieces were referred to as “Betton Hills.” Mr. Winthrop inherited his first piece of land in 1932, and he began to develop that same piece a few years later in 1936. Mr. Winthrop inherited additional pieces of land at various other dates (1946, 1948 and 1960).

In 1936, Mr. Winthrop made his first sale by selling a portion of the land he had began developing earlier that same year. Mr. Winthrop continued to develop his land and sell portions of it to interested buyers up until his death in 1963. Hence, his sales operation spanned multiple decades. Though he did not create a business office, he devoted massive amounts of energy to developing the land so as to make it more marketable. What’s more, the income derived from real estate sales constituted the majority of his entire income for many years prior to his death. Mr. Winthrop also began to include “real estate” as his occupation for a number of years in official documents before his death. The question before the court was: should Mr. Winthrop’s activities receive capital gain treatment given the facts which underlay them?

Law

There are a number of common law tests which have been developed to aid the court in its determination of capital gain treatment. Though this is true, the court must also be certain to view each case as an independent matter and provide each case with its own analysis.

In United States v. Winthrop, there was no disagreement made by the Fifth Circuit regarding the fact that the land was held “primarily for sale” by Mr. Winthrop. The only remaining issue was whether the sales executed could be classified as sales made in the ordinary course of business. The Fifth Circuit stated that the ordinary course of business determination depends on whether selling the land was Mr. Winthrop’s primary purpose in holding the land.

Ruling

The Fifth Circuit overturned the trial court’s finding and determined that the sales made by Mr. Winthrop were made in the ordinary course of business and therefore should be disqualified from capital gain treatment. Mr. Winthrop clearly had a reasonably strong case given that he did not actively and aggressively advertise his properties, he did not maintain a sales office, did not reinvest his profits in other real estate (for the purpose of growing his business) and he initially acquired the real estate through inheritance rather than purchase. There were certainly many facts capable of supporting his position. Ultimately, the fact that Mr. Winthrop only used the properties for the purpose of selling to customers proved to be decisive.

Image credit: Mark Moz

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johnAbout john
Seattle CPA+John Huddleston has written extensively on tax related subjects of interest to small business owners. He is a graduate of Washington State University and the University of Washington School of Law.

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