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

A Note on the Capital Gains Tax

Capital Gains Tax Rate Money Funds

Capital Gains

As the previous installment of Huddleston Tax Weekly made clear, our tax code draws a distinction between ordinary income and capital gains. In general, ordinary income is income derived throughout the course of running a business or trade; capital gains result from the sale of a “capital asset” (which is defined by the code). It is important for people to understand how their behavior will be classified because these classifications carry particular tax implications. In conjunction with criteria from the tax code, our common law also provides additional guidelines for classifying a given source of income.

The capital gains tax has long been the focus of controversy: many argue that its current low rate disproportionately benefits wealthy citizens and that it should be increased, while others contend that a lower rate actually stimulates more economic growth and that such growth benefits citizens of all socioeconomic levels. The evidence in favor of the latter position is considerable and should strike most objective observers as persuasive. The capital gains tax rate has fluctuated widely over the past several decades, and there is an unmistakable positive correlation between low rates and greater revenues generated from capital gains. This association may appear counterintuitive upon first glance, but a bit more scrutiny makes it very easy to understand: when the tax rate is high, people simply hold on to their assets and avoid paying the tax at a high rate; when the rate is low, people sell more frequently and this results in greater total revenues for the government.

Low rates also appear to influence stock market prices. The tax cuts in the 1980s, the late 1990s, and in 2003 all coincided with significant stock market gains. What’s more, there is also an association between reduced rates and business development as measured by initial public offerings (IPOs), money raised from IPOs and the money committed to venture capital firms. Investors are less willing to commit funds when capital gains tax rates are high; this agrees with common sense given that higher rates will result in smaller returns on investment.

Though lower capital gains tax rates do appear to provide greater benefits to the economy as a whole, there is no denying that such rates disproportionately benefit higher income levels. The clear majority of gains from capital asset sales are made by those with incomes above $200,000. Going forward, it appears that the debate on capital gains tax rates will be framed by this question: can our society accept the positive impact of lower rates even though lower rates tend to benefit wealthy individuals disproportionately?

References

Moore, Stephen. “Capital Gains Taxes.” David R. Henderson (ed.). Concise Encyclopedia of Economics. Indianapolis: Library of Economics and Liberty.

Image credit: TaxRebate.org.uk

Byram v. United States & the 7 Pillars of Capital Gain Treatment

Real Estate Property Transaction Sales Business

Real Estate Transactions

The tax code draws a distinction between ordinary income and income derived from the sale of a capital asset, or “capital gain.” In most instances, this distinction is straightforward and there is little confusion about whether income falls into one category or the other. Every now and then, however, a situation develops in which the classification of income is a difficult matter. There is much at stake in the determination of whether income is either ordinary or derived from the sale of a capital asset: capital gains can be taxed at substantially lower rates than ordinary income.

The case of Byram v. United States (1983) provides one example of the difficulty occasionally involved in distinguishing between a “business” sale – which would trigger ordinary income – and an investment sale. The tax code recognizes a number of general characteristics of business sales and investment sales; sometimes a transaction possesses characteristics of both a business sale and an investment sale, or it lacks enough characteristics of one type of sale to merit a definitive classification.

If you engage in real transactions with any kind of regularity, be sure that you’re aware of these characteristics so you can avoid any unpleasant surprises when tax time rolls around.

Facts

John Byram owned multiple pieces of real estate. Between the years 1971 and 1973, Byram sold a total of 22 pieces of real estate for a gross return of $9 million and a net profit of $3.4 million. He sold 7 pieces of real estate in 1973 alone.

Importantly, Byram did not have a business office; he did not advertise; he did not utilize the services of a broker; he did not subdivide the land; he spent only a small amount of time and effort engaging in the transactions; all of the transactions were initiated by the purchasers.

Law

The question of whether a transaction – or set of transactions – can receive “capital gain treatment” (and therefore be subject to the rates applicable to capital gains) depends on the characteristics of the transaction. Courts recognize the 7 “pillars” of capital gain treatment when deciding whether a given transaction should be deemed either an investment sale or business sale.

The 7 Pillars of Capital Gain Treatment can be summed up as follows: (1) purpose of the acquisition of the property and duration of ownership; (2) extent of the efforts to sell the property; (3) number, extent, continuity and magnitude of the sales; (4) time and effort devoted to developing the land and advertising to increase sales; (5) use of a business office; (6) degree of supervision exercised by the owner over any representative selling the property; (7) overall time and energy dedicated to the sales.

The question before the court was: do the transactions made by Byram between 1971-1973 merit capital gain treatment based on the guidelines established through the 7 pillars?

Ruling

The court (the Court of Appeals for the Fifth Circuit) affirmed the ruling of the lower court in favor of Byram. The transactions engaged in by Byram (and his buyers) possessed enough characteristics of an investment sale to trigger capital gain treatment. The determination of whether capital gain treatment is warranted requires an independent analysis for each individual case; in the Byram case it was clear that the evidence supported the conclusion that the properties were not sold as part of a business enterprise but as investments.

The Byram case is highly useful for people who own multiple pieces of real estate and who are considering selling these pieces in the future. It is important for these owners to be conscious of the facts of Byram so that they can be certain to receive capital gain treatment.

Image credit: PT Money

Readers who enjoyed this essay should check out our presentation of the tax benefits of real estate ownership by CPA Jessica Chisholm

A Quick Look at the Tea Act of 1773

British Tea Act Parliament America Company

The Tea Act of 1773

It has been noted before on Huddleston Tax Weekly that there is a strong tendency in contemporary society to associate taxes with things which are mundane, dull and boring. We’ve also noted that these associations are based on the conditions of our society at the present moment and would make little sense if based on conditions from previous eras. Throughout the bulk of recorded history, taxes have been closely tied to a host of exciting and oftentimes frightening things. With few exceptions, substantive changes in tax policy have accompanied sweeping changes to the existing social order, and the Tea Act of 1773 does not stray from this general rule.

As we will see, the significance of the Tea Act of 1773 stems mostly from the way it was received by the American colonists of the British Empire. The purpose of the act was not simply to generate revenue, but to provide confirmation of the power of the British Parliament to directly tax the American colonies. The act not only failed to achieve its intended goals but also sparked a reaction which ultimately altered the entire course of world history.

Historical Setting

The passing of the Tea Act was surrounded by a number of important political and business phenomena. One of the most pressing concerns of the British Parliament during this (pre-revolutionary) era was to have its power to tax the American colonies fully accepted by American colonists. This concern was among the driving forces behind the so-called Townshend Acts. The Townshend Acts consisted of a series of measures which dealt with a variety of issues relating to the administration of the American colonies. The first of these acts – the Revenue Act of 1767, also referred to simply as the Townshend Act – imposed a tax on tea (and several other items) imported to the colonies. The act forbade the colonists to purchase tea from any supplier other than Great Britain.

The Revenue Act was met with serious opposition from the American colonists who swiftly condemned the measure as a piece of blatant tyranny. Thenceforth the aim to legitimize the taxing power of the British Parliament over its colonies intensified.

Before the Tea Act, the British East India Company had been directed to sell its tea exclusively in London. Tea from the company which did make it to North America did so only through outside merchants who specialized in international sales. By the time the tea reached the market for American consumers, markups and the tax imposed by the Revenue Act made the tea an unattractive buy. As a consequence of these policies, an underground market developed in which foreign (Dutch) tea was smuggled into the colonies and sold at much lower prices. In addition to legitimizing the Parliament’s taxing power, the Tea Act was also passed with the aim of improving the financial condition of the East India Company and shutting down the flow of smuggled foreign tea.

The act contained these terms: the East India Company had the ability to ship its tea directly to North America; the company was no longer bound to sell its tea exclusively in London; duties on tea charged in Britain which were shipped out for international sale would either be refunded when exiting the country or not imposed; and finally, those receiving the company’s tea were required to pay a deposit up front following delivery.

Colonial Reaction

The British lawmakers in the Parliament had reason to believe that the Tea Act would produce favorable results: the tea sold by the East India Company was of higher quality than Dutch tea, and since its price had been lowered, the lawmakers could sensibly infer that the smuggled Dutch tea would lose its competitive advantage. Unfortunately for the British lawmakers, the act would be opposed not only by those colonists who continued to reject Parliament’s ability to lay the tax of the Revenue Act, but also by colonial merchants and underground businessmen who had a financial interest in preventing the ascendancy of the East India Company.

After the act was passed, the East India Company sent a number of ships to America in the hope of unloading its tea on the market; none of these ships was to unload its cargo successfully. Most famously, the ships which arrived at the ports in Boston were raided by irate colonists who tossed the company’s tea into the harbor. This incident came to be known as the “Boston Tea Party,” though it was referred to as the “Destruction of the Tea” in its own time. The colonial stance on the Parliament’s ability to impose taxes was clear, and the stage was set for the massive insurrection which was to eventually give birth to the sovereignty of the States.

Image credit: Prudence Styles

Bailey v. Drexel Furniture Co. & the Child Labor Tax Law of 1919

Drexel Child Labor Tax Law Constitutional Penalty

Supreme Court

To most contemporary Americans, exploitative child labor practices seem like an ancient, prehistoric phenomenon far removed from the context of advanced civilization. But, crazy though it sounds to modern ears, such practices sadly occurred on a fairly regular basis in the not too distant past of our society. In fact, our society was grappling for ways to combat this problem less than 100 years ago. In 1919, Congress addressed this issue through its Child Labor Tax Law. The law imposed a tax of 10 percent on the net profits of companies which employed children (as defined by the age limits of the law).

With the Child Labor Tax Law, the Congress was attempting to curtail child labor by regulating business through its taxing power. In effect, Congress was “punishing” businesses for exploiting the labor of children through the tax.

One curious result of constitutional restrictions on government power is that occasionally good laws are thrown out. Obviously, no one in 1919 disputed the desirability of a law which aimed to prevent abusive child labor practices; the issue which arose in Bailey v. Drexel Furniture Co. (1922) was whether the Congress went beyond the bounds of its constitutionally delineated authority by using a “tax” to stop unethical behavior. As we will see, the Bailey case illustrates the difficulty involved with maintaining restrictions on government power even when such power is being tailored for good ends.

Facts

Drexel (plaintiff in original suit and respondent in appellate case) was a furniture manufacturing company which employed a child under the age of 14 during the 1919 tax year. In agreement with the Tax Law, Bailey (the tax collector for the government) assessed a tax of $6,312.79 for such behavior. Drexel paid the full amount and then sued for recovery.

Drexel argued that the tax was a covert “penalty” designed to punish undesirable behavior and that the law was therefore an unconstitutional attempt to regulate business. The government argued that the levying of the tax was fully consistent with its broad taxing powers as prescribed by Article One of the Constitution.

Law

The Congress has the power to lay and collect taxes as outlined by the Constitution. However, this power is not unlimited and when the Congress attempts to step beyond its bounds such attempts must be struck down.

Ruling

The Supreme Court ruled in favor of Drexel (as did the lower court). Although no issue was raised as to the desirability of the Tax Law, the court reasoned that the tax created by the law was in fact a disguised penalty and it was therefore impermissible. The court defined a “tax” as a source of revenue for the government, while a penalty is a punishment intended to deter certain behavior. Penalizing unethical behavior is not a function of the taxing power of the Congress but should be addressed through the criminal law of individual states.

The decision in Bailey was controversial in part because other taxes aimed at curtailing (or in some sense penalizing) certain behavior had been upheld. For instance, excise taxes on drugs and firearms have not been regarded as improper attempts by the Congress to regulate business. But the court in Bailey recognized that an overly broad reading of Congress’ taxing power could result in the obfuscation of its proper function and unfairly reduce the power of the states.

Image credit: Davis Staedtler

United States v. E. C. Knight Co. & the Scope of the Sherman Antitrust Act

Business Monopoly Law Antitrust Act Commerce

The Regulation of Monopolies

One of the chief functions of our government is to ensure a fair and equitable market in which businesses may compete to offer goods and services to consumers. Our law has been developed and shaped in accord with this function. In order for free enterprise to flourish, our government must see that the marketplace is kept competitive and that attempts to obstruct or excessively limit competitiveness be swiftly eradicated. In the late nineteenth century, one particular law – the so-called Sherman Antitrust Act of 1890 – was passed with the purpose of promoting business competitiveness. The law forbade individuals from creating (or attempting to create) a monopoly of any part of the trade or commerce among the states or with foreign nations. This law stood in its original form until 1914 when it was expanded in scope by the Clayton Antitrust Act.

Very soon after the Sherman act was passed, disputes arose which required that the scope of the act be clarified. The case of the United States v. E. C. Knight Co. (1895) was one of these disputes. As we will see, the ruling of this case showed that the scope of the Sherman act was not so far-reaching that it could suppress a monopoly of the manufacture of a good.

Facts

E. C. Knight Company (the defendant) was acquired by the American Sugar Refining Company. This acquisition gave the company control over approximately 98 percent of the sugar refining industry. The U.S. government (plaintiff) attempted to utilize the provisions of the Sherman act to prevent the acquisition and thwart the creation of the virtual monopoly. The key question was whether the Sherman act allowed the government to interfere with a monopoly of the manufacture of a good as opposed to its distribution across state lines.

Law

The U.S. Constitution grants the Congress the power to regulate commerce among the states. The Sherman Antitrust Act included provisions which were ultimately in agreement with this basic power. The second section of the Sherman act reads as follows: “…Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony…”

The scope of the Sherman act clearly extends to monopolies of the distribution of a good; but did the Sherman act extend to monopolies of the manufacture of a good on a strictly local level?

Ruling

The court ruled that the Sherman act did not apply to this type of locally defined activity. However, since the acquisition resulted in a monopoly over the manufacture of a “necessity of life” (in the words of the court), this meant that the acquisition could be subject to individual state regulation.

In effect, the ruling of this case significantly curtailed the authority of the Congress to regulate the national economy as it declared manufacturing monopolies to be local matters. This restrictive view on Congressional authority to regulate commerce would remain unchanged until the late 1930s.

The case of the United States v. E. C. Knight Co. shows clearly some of the difficulties involved in trying to balance the ideals of a competitive marketplace and limited government. And for this reason the legacy of E. C. Knight Co. represents different things to people on different places of the ideological spectrum. However it is interpreted in any individual instance, there can be no denying its stature as a pivotal case in U.S. judicial history.

Image credit: VasenkaPhotography

Dickinson v. Dodds & the Legal Importance of Time

Time Law Contract Formation Property

Legal Weight of Time

In so many areas of life, timing is of extreme importance. Timing is particularly important in the business world. As so many stock brokers and other businesspeople are aware, small portions of time can mean the difference between many thousands – and even millions – of dollars. Smart businesspeople know that most – if not all – sound business decisions involve an element of time: a sound decision is not solely about what transpires, but when something transpires as well.

Unsurprisingly, business contracts follow this same rule: our law recognizes that time is something which naturally carries value of itself. In contract parlance, time has bargaining power, and as such it can be used to provide consideration for an agreement. The case of Dickinson v. Dodds (1876) should be required reading for every business professional: in this famous case, an offer was extended for a certain period of time, but because nothing of value was given by the prospective buyer, the seller was free to withdraw the offer prematurely and give a new offer to a third party. Dickinson v. Dodds provides clear evidence of the legal significance of time in contract formation.

Facts

Dickinson (the buyer and plaintiff) received an offer from Dodds (the seller and defendant) regarding a piece of real property. Dodds offered to sell his property to Dickinson for a sum of £800. Dodds made the offer on Wednesday and verbally agreed to keep the offer open until 9 am on Friday. On Thursday, while Dickinson was still contemplating the offer, a third party (Mr. Berry) notified Dickinson that the property had already been sold to another party (Mr. Allan). Dickinson, believing that the original offer was still viable, met Dodds at a railway station at approximately 7 am on Friday and attempted to accept the price of £800 for the property. Dodds informed Dickinson that the property had indeed already been sold to the other party and that, although the original offer was apparently still open until Friday morning, acceptance was no longer possible.

Dickinson brought suit against Dodds (and Mr. Allan) in order to nullify the sale on the grounds that a valid offer was still “on the table.”

Law

In the formation of contracts, time has value, and therefore it must be bargained for in order for one party to benefit from it. Hence, if a buying party wishes to keep an offer open for a certain period of time while he contemplates its merits, he must give something of value in return otherwise there is no consideration for the period of time given by the selling party.

Ruling

The court (the Court of Appeal of the Chancery Division in England) ruled in favor of Dodds. Dickinson’s interpretation of the communication from Dodds, which held that a third party could not purchase the property until after 9 am on Friday morning, was false. Though, on the surface, it may have seemed like Dickinson had the exclusive privilege of buying the property until Friday morning, this was not actually the case because the element of time had not been bargained for.

Dickinson’s acceptance at approximately 7 am on Friday was invalid given the fact that he had already received reliable communication of acceptance by another party. Dickinson’s attempted acceptance on Friday morning was predicated on the assumption that Dodds was unable to extend an offer to a different party until after 9 am on Friday. This assumption was false.

The lesson is clear: the significance of time is such that it is encoded in our law. Businesspeople must be aware of the fact that time has this type of legal importance as they engage in business negotiations.

Image credit: Sean MacEntee

What Every Business Owner Should Know About Contract Law

Contract Law Business Owner Element

Contract Law for Business Owners

It is unrealistic to expect every business owner to have a thorough command of contract law. Running a business is a very demanding job, and so unless they are fortunate to have a formal background in law business owners simply do not have the time required to master all the finer points of contracts. But, though mastery may be unattainable, most – and ideally all – business owners should make it a priority to acquire at least a basic understanding of contract law.

Having a grasp of basic contract principles is beneficial to business owners in myriad ways. Business owners can look forward to negotiating deals with other businesspeople with greater confidence; they can confer with business lawyers with greater ability; they will have a better sense of the implications which can follow from discussions with employees. In short, they will be able to run all areas of their business with an increased level of independence.

Business owners can best serve themselves by gaining a firm understanding of the elements of a contract. The elements of a contract are relatively easy to learn; but, as we have seen in prior installments of Huddleston Tax Weekly, tricky things start to emerge when these seemingly straightforward elements apply to complex factual scenarios.

Contract Elements

There are five elements which must always be met in order for a valid (i.e. enforceable) contract to be formed: these elements are offer, acceptance, consideration, legality and capacity. The sixth element of a contract – writing – need only be met in certain rather than all cases.

The rationale of each of these elements is quite straightforward. In order for a contract to be formed, there must be an offer which discloses clearly what the terms of the agreement will be. These terms must be clearly understood by all parties. The terms must be fully accepted by all parties. There must be adequate consideration between the parties – that is, there must be an exchange of things which are of roughly equal value. The terms of the contract must be legal – in other words, people cannot contract for goods or services which are prohibited by law. And the parties of a contract must have the capacity – meaning they are of sufficient age and mental condition – to accept the terms of the agreement.

In cases involving things which are of high monetary value the parties must also put the terms of the contract in writing. However, if writing is not required, a valid contract has been formed when all of the other five elements have been satisfied.

The Enforceability of Promises

Contract law is concerned with determining which agreements (or promises) are enforceable by courts. The elements listed above are required in order for an agreement to be facially valid; however, though this is the case, in certain instances promises may be enforced despite the fact that not all elements were met. For example, the doctrine of promissory estoppel can be invoked when someone relies on a promise to their detriment even though a facially valid contract may not have been formed.

As mentioned above, complexity arises when these elements are applied to real factual scenarios. The factual details of agreements may yield doubt as to whether specific contractual elements were properly satisfied; courts are designed to step in and settle these disputes. Our entire body of contract case law is a record of how parties can have very disparate views of the same facts which surround the creation of a contract.

It is important for business owners to fully understand the elements of a contract; but they must also be aware of how easily disputes can arise as to whether elements were adequately met.

Image credit: Chris Potter

Conklin v. Davi: Adverse Possession and Marketable Titles

Real Estate Adverse Possession Title

Real Estate

Huddleston Tax Weekly will continue to examine legal cases which involve real estate because such cases can be of substantial value to our readers who are either current or future property owners. When engaging in real estate transactions, it is always best to draw up a contract which captures every conceivable detail of the exchange. Developing a thoroughly detailed contract will help to avoid the possibility of any legal disputes. The case of Conklin v. Davi (1978) is an interesting example of a dispute which could have been avoided if the parties had created a more detailed contract.

Facts

Conklin (the plaintiff) sold real estate to Davi (the defendant). A section of the property was acquired through adverse possession. Adverse possession is the process through which real property may be obtained without a monetary transaction; adverse possession occurs when an individual actively and openly “possesses” land for a specified period of time. The contract between the parties omitted reference to the fact that a portion of the land was acquired through adverse possession. Davi wished to obtain a title which was wholly “marketable” so that the land could be sold again in the future without complication. Davi believed that a marketable title could not be gained through the transaction due to the fact that a piece of the land had been acquired through adverse possession. Based on this belief, Davi refused to conclude the transaction. Conklin sued for specific performance and Davi counterclaimed for rescission of the contract.

Law

The critical issue before the court was whether land acquired through adverse possession can have a marketable title when transferred via sale. The answer is yes: provided that the seller shows proof that the land was acquired legally through adverse possession, the buyer is capable of obtaining a title which is wholly marketable.

Ruling

The court (the Supreme Court of New Jersey) ruled in favor of the plaintiff (Conklin). The defendant could have procured a marketable title to the entire land as long as the plaintiff provided proof of ownership through adverse possession. The court ordered the plaintiff to provide such proof before suing the defendant for specific performance.

As Conklin v. Davi shows, land acquired through adverse possession can yield a wholly marketable title. The issue was that the plaintiff did not provide proof of ownership when the contract was formed; another issue was that the parties were unaware that adverse possession could produce a marketable title. The lesson is clear: before selling or buying real estate, be sure to conduct research and develop a sufficiently detailed contract!

Image credit: Emmanuel Ku

To learn more about the tax benefits of real estate ownership view the following webcast

Jacob & Youngs v. Kent: A Lesson on Substantial Performance

Huddleston Tax Weekly will continue to feature articles on contracts because it is very important for business owners to have at least a basic knowledge of contract law. Business owners negotiate and execute contracts on a recurring basis and so an understanding of fundamental contract principles is essential. Today we will discuss the concept of substantial performance and demonstrate how this concept informs how damages are settled when a contract has been breached.

Many people assume that when a breach of contract has occurred damages necessarily follow in all instances. In reality, this is not always the case. If an offending party violates a contract in such a way that the violation does not materially affect the goals of the contract then damages usually do not follow. The case of Jacob & Youngs v. Kent (1921) is a famous example of a breach which ended up not leading to any damages.

Facts

The plaintiff (Jacob & Youngs) contracted with defendant (Kent) to build a house. The defendant wished to have a specific brand of pipe installed and the contract reflected this wish. When the plaintiff was nearly completed with the project the defendant discovered that a different brand of pipe had been used. The pipe used by the plaintiff was of equal quality to the brand of pipe desired by defendant. The plaintiff originally brought suit in order to receive the remainder owed by the defendant on the original contract price. The defendant argued that the breach was material and requested that the existing pipe should be replaced with the desired brand. The plaintiff argued that using a different brand was a trivial error and that replacement would present an oppressive burden.

Law

The doctrine of substantial performance prevents trivial offenses from totally wiping out an existing contract. When a breach of contract is deemed trivial such that it does not materially affect the goals of a contract the offending party must pay for whatever difference in value occurs as a consequence of its breach. The offending party is not required to redo every part of the contract.

Ruling

The court (New York Court of Appeals, highest court in the state of New York) found that using a pipe of a different brand but of the same type and quality was a trivial error. Ordering the plaintiff to completely replace the existing pipe with the desired brand would be oppressively expensive. However, since the plaintiff did breach the contract, the defendant is entitled to the difference in value between the product received and the product promised. In this case, the difference in value was literally zero because the two brands of pipe were of the same quality.

In the world of business, these kinds of trivial mistakes are quite common. Having an awareness of the concept of substantial performance can give you a sense of what to expect when these sorts of errors happen.

Huddleston Tax CPAs of Seattle & Bellevue
Certified Public Accountants Focused on Small Business

(800) 376-1785
40 Lake Bellevue Suite 100, Bellevue, WA 98005

Huddleston Tax CPAs & accountants provide tax preparation, tax planning, business coaching, Quickbooks consulting, bookkeeping, payroll and business valuation services for small business. We serve Seattle, Bellevue, Redmond, Tacoma, Everett, Kent, Kirkland, Bothell, Lynnwood, Mill Creek, Shoreline, Kenmore, Lake Forest Park, Mountlake Terrace, Renton, Tukwila, Federal Way, Burien, Seatac, Mercer Island, West Seattle, Auburn, Snohomish and Mukilteo. We have a few meeting locations. Call to meet John Huddleston, J.D., LL.M., CPA, Tawni Berg, CPA, Jennifer Zhou, CPA, Jessica Chisholm, CPA or Chuck McClure, CPA. Member WSCPA.