Capital Gains Treatment Under Rev. Rul. 82-51
Analyze how Rev. Rul. 82-51 guides the tax treatment for selling an agency contract, focusing on the distinction between a capital asset sale and ordinary income.
IRS Revenue Ruling 82-51 provides guidance for business owners with exclusive agency agreements on the tax implications of receiving payment for terminating their contractual rights. This is relevant for professionals, like insurance agents, whose business is built around a contract with a single company. The ruling clarifies how proceeds are taxed, but subsequent law changes have added new considerations.
Qualifying for Capital Gain Treatment
For a payment to qualify for capital gain treatment, the transaction must be a “sale or exchange.” A simple contract cancellation is not enough. While tax law provides “sale or exchange” treatment for terminating a distributor’s agreement, this rule excludes personal service contracts like insurance agencies. Revenue Ruling 82-51 involved an agent who sold their entire agency—including all files, records, and contract rights—to another agent, which constitutes a sale.
The asset’s classification is also a factor. The Tax Cuts and Jobs Act of 2017 mandates that gain from the sale of self-created intangible assets like patents or secret formulas is treated as ordinary income. This can affect how proceeds from the sale of an agency and its related goodwill are taxed.
A component of such a sale is the intangible asset of goodwill. The value paid by the buyer includes the established business reputation and client relationships. Including goodwill in the sale reinforces that the transaction is a sale of business assets, not a payment for future income.
Differentiating from Ordinary Income
Payments that are a substitute for future income that would have been earned under the contract are treated as ordinary income. For example, if a company pays an agent a lump sum to terminate their contract, but the rights are not sold or transferred to another party, the payment is considered ordinary income as compensation for lost future commissions.
Payments that represent compensation for past services rendered are also classified as ordinary income. The source of the payment must be the sale of the asset itself, not a settlement of earned but unpaid commissions or fees. The character of the income is determined by what the payment replaces.
Sales agreements often include a covenant not to compete, where the seller agrees not to compete with the buyer. If a portion of the sales price is allocated to this covenant, that amount is treated as ordinary income. This payment is for the seller’s agreement not to perform services and is taxed separately from the business assets.
Reporting the Transaction
When a transaction qualifies for capital gain treatment, it must be reported to the IRS. The primary forms are Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses. These forms calculate the net capital gain or loss, which is then carried to Form 1040.
On Form 8949, the taxpayer provides details about the sale, including a description of the property, acquisition and sale dates, sales price, and cost basis. The gain or loss is the difference between the sales price and the basis.
Determining the cost basis for an intangible asset like a self-created agency contract can be straightforward. If the agent built the business without an initial purchase cost, the basis is often zero. In this case, the entire sales price, less any transaction costs, becomes a taxable gain.