Revenue Ruling 63-26: Ordinary Income or Capital Gain?

Revenue Ruling 63-26 is a guideline from the Internal Revenue Service (IRS) that addresses the tax nature of payments for canceling business contracts. When a contract like a distributor agreement or a lease is terminated early, the payment can be taxed as either ordinary income or a capital gain. This ruling provides a framework for determining the correct tax treatment, which impacts the recipient’s tax liability.

Payments Treated as Ordinary Income

A payment received for canceling a contract is treated as ordinary income if it acts as a substitute for future earnings. This is known as the “substitute for future income” doctrine, where if a payment compensates for profits that would have been earned had the contract continued, it is taxed at ordinary income rates. This prevents taxpayers from converting future ordinary income into a more favorably taxed capital gain.

For example, a distributor has an exclusive contract to sell a manufacturer’s products for five years. If the manufacturer terminates the agreement after two years and pays a lump sum based on projected net profits for the remaining three years, the IRS views this as ordinary income. The payment is a replacement for future sales revenue the distributor was entitled to earn, not a payment for the sale of the contract itself.

Payments Qualifying for Capital Gain Treatment

A cancellation payment may qualify for lower capital gains tax rates. For this to apply, the payment must be for the relinquishment of the contract itself, which is considered a capital asset, and the transaction must qualify as a “sale or exchange.”

The Internal Revenue Code specifies that amounts a lessee receives for canceling a lease are considered payments in “exchange” for that lease. A similar rule applies to a distributor canceling an agreement, but only if the distributor has a substantial capital investment in the distributorship. In these statutorily defined situations, the “exchange” requirement is automatically met.

For contracts not covered by a specific rule, the distinction is whether the recipient is giving up a substantial property right, rather than being compensated for lost profits. If the cancellation extinguishes a valuable, long-term business right, the payment can be treated as proceeds from the sale of a capital asset. This allows the gain, calculated as the payment received minus the taxpayer’s basis in the contract, to be taxed at long-term capital gains rates if the contract was held for more than one year.