Category: Miscellaneous Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Background Taxpayer, a partnership, sold personal and improved real property in 1996. TP agreed to make various improvements to the property subsequent to the sale. The improvements were made in 1997. Issue What is the proper tax treatment of the expenses incurred in 1997 and how are those expenses treated on the partnership tax return? Answer The expenses are treated as an additional cost of the sale and have the same character (capital, ordinary, or Section 1231) as if the expenses had been incurred at the time of the sale. Discussion This question is a clear example of what has come to be referred to as the Arrowsmith Doctrine. In Arrowsmith v. Comr., 344 U.S. 6 (1952), the taxpayers were shareholders of a corporation engaged in the business of mineral extraction. The corporation was liquidated. Some years later, a governmental authority forced the taxpayerspresumably under some theory of transferee liabilityto incur substantial costs related to an environmental problem caused by the corporation's mineral extraction operation. The taxpayers argued that the additional costs should be ordinary expenses. The court observed that if the expenses had been incurred at the time of liquidation, they simply would have reduced the proceeds of liquidation and thus reduced the taxpayer's capital gain therefrom. The expenses should not change their character simply because they were incurred in a later year. Arrowsmith has been applied in a wide variety of circumstances and I see no reason the case should not apply here. Clearly, if the expenses had been incurred prior to the sale, they would simply have represented an additional cost of the sale and thus decreased whatever gain was recognized on the sale (on increased any loss). Given the type assets you mentioned in your memorandum, I would suspect that any gain or loss from the saleafter consderation of any Section 1245 or 1250 recapturewould be Section 1231 gain or loss. It seems to me that these additional expenses would be treated as Section 1231 loss. Mechanically speaking, I would put the expenses as a cost on Form 4797 as against zero proceeds and attach a white-paper schedule explaining that these costs are post transaction costs and are being handled in accordance with the Arrowsmith decision. I would also include the case citation in the scheduleS. |
