For the time being, and unless and until Congress enacts significant changes to the Internal Revenue Code (the Code), the distinction between ordinary income and capital gain is a fundamental one. Taxpayers and their advisors are always on the lookout for opportunities to put income into the capital gain pigeonhole, where it is generally taxed at favorable rates, and over the years the courts and the Internal Revenue Service developed a variety of doctrines to prevent the capital gain exception from swallowing the ordinary income general rule.

Section 1234A of the Code represents Congress's reaction to what it viewed as an overly strict application of one of those doctrines, specifically the conclusion that, because the statutory rules governing capital gain require a “sale or exchange,” capital gain treatment was unavailable in a transaction in which the taxpayer received consideration for extinguishing a right that the taxpayer held, as distinguished from transferring that right to a third party. The scope of §1234A was considered in a recent order of the Tax Court in Hurford Investments No. 2 v. Commissioner (Dkt. 23017-11, April 17, 2017), in which the principal issues were the tax basis of a partnership (HI-2) in so-called “phantom stock” issued by a corporation, and whether gain from the receipt of payment in respect of the phantom stock was capital gain under §1234A.

Background

Gary Hurford received phantom stock from his employer, the Hunt Oil Company, in connection with his employment. The phantom stock was a right to deferred compensation required to be “redeemed,” for an amount per phantom share approximating the value of an actual share of Hunt Oil common stock, on the fifth anniversary of a qualified termination of service.