US Rev. Rul. 59-91, 1959-1 C.B.

215, holds that where a taxpayer engages in

extensive land development activities, such as lot sudivision, installation o!
utilities, and paving streets, all in order to !acilitate the sale and derive the
maximum proceeds !rom the disposition o! the property, the taxpayer is
holding property !or sale to customers in the ordinary course o! trade or
usiness.
http://www.irafinancialgroup.com/using-a-self-directed-ira-llc-what-type-of-transactions-may-trigger-
the-ubti-tax.php
Using a Self Directed IRA LLC, what type
of transactions may trigger the UBTI tax
In general, most passive investments that your Self-Directed IRA LLC might invest in are exempt from
U!I" Some examples of exempt type of income include# interest from loans, dividends, annuities,
royalties, most rentals from real estate, and gains$losses from the sale of real estate"
%hen an exempt organi&ation such as an IRA underta'es any development activities in connection (ith
selling real estate, )eyond passively placing the property for sale either directly or through a )ro'er, the
issue arises under Internal Revenue code *+,-).-*.-A. (hether the real estate is /property held primarily
for sale to customers on the ordinary course of the trade or )usiness"0 An organi&ation that engages in
the sale of property to customers in the ordinary course of the trade or )usiness is characteri&ed as
acting as a /dealer"0
1undamental to considering (hether an exempt organi&ation is a /dealer0 of real property is (hether the
property itself is held /primarily0 for resale to customers in the ordinary course of a trade or )usiness" In
2alat v" Riddell, 343 U"S" *54 -+455., the U"S" Supreme Court interpreted the meaning of the phrase
/held primarily for sale to customers in the ordinary course of trade or )usiness0 under Internal Revenue
Code Section +,,+-+." !he IRS has often applied the principles derived under Internal Revenue Code
Section +,,+ to rulings interpreting the language of Internal Revenue Code Section *+,-).-*." !he Court
interpreted the (ord /primarily0 to mean /of first importance0 or /principally"0 y this standard, ordinary
income (ould not result unless a sales purpose is dominant" oth the courts and the IRS concluded that
a taxpayer may ma'e /reasona)le expenditures and efforts0 -such as su)dividing land , construction of
streets, the provision of drainage, and furnishing of access to such a necessity as (ater, as part of the
/li6uidation0 of an investment asset (ithout )eing treated as engaged in a trade or )usiness"
!he U!I generally applies to the taxa)le income of /any unrelated trade or )usiness7regularly carried
on0 )y an organi&ation su)8ect to the tax" !he regulations separately treat three aspects of the 6uoted
(ords9/trade or )usiness,0 /regularly carried on,0 and /unrelated"0
!rade or usiness# In defining /unrelated trade or )usiness,0 the regulations start (ith the concept of
/trade or )usiness0 as used )y Internal Revenue Code Section +5,, (hich allo(s deductions for
expenses paid or incurred /in carrying on any trade or )usiness"0 Although Internal Revenue Code
Section +5, is a natural starting point, the case la( under that provision does little to clarify the issues"
ecause expenses incurred )y individuals in profit-oriented activities not amounting to a trade or
)usiness are deducti)le under Internal Revenue Code Section ,+, , it is rarely necessary to decide
(hether an activity conducted for profit is a trade or )usiness" !he fe( cases on the issue under Internal
Revenue Code Section +5, generally limit the term /trade or )usiness0 to profit-oriented endeavors
involving regular activity )y the taxpayer"
Regularly Carried :n# !he UI! only applies to income of an unrelated trade or )usiness that is
/regularly carried on0 )y an organi&ation" %hether a trade or )usiness is regularly carried on is
determined in light of the underlying o)8ective to reach activities competitive (ith taxa)le )usinesses"
!he re6uirement thus is met )y activities that /manifest a fre6uency and continuity, and are pursued in a
manner generally similar to compara)le commercial activities of nonexempt organi&ations"0 Short-term
activities are exempted if compara)le commercial activities of private enterprises are usually conducted
on a year-round )asis -e"g", a sand(ich stand operated )y an exempt organi&ation at a state fair., )ut a
seasonal activity is considered regularly carried on if its commercial counterparts also operate
seasonally -e"g", a horse racing trac'." Intermittent activities are similarly compared (ith their
commercial rivals and are ordinarily exempt if conducted (ithout the promotional efforts typical of
commercial endeavors" 2oreover, if an enterprise is conducted primarily for )eneficiaries of an
organi&ation;s exempt activities -e"g", a student )oo'store., casual sales to outsiders are ordinarily not a
/regular0 trade or )usiness"
efore it can )e determined (hether an activity is seasonal or intermittent, the relevant activity must )e
identified and 6uantified, a step that is often trou)lesome"
!he type of income that generally could su)8ect a Self-Directed IRA LLC to U!I is income generated
from the follo(ing sources#
Income from the operations of an active trade or )usiness
Income earned from a convenient store
Income earned from a manufacturing )usiness
usiness income generated via a passthrough entity, such as an LLC or partnership
Income earned through an active )usiness o(ned )y an LLC in (hich the IRA is an investor
Unrelated De)t 1inanced Income
Using a nonrecourse loan to purchase a property
Using margin on a stoc' purchase
Income from a real estate investment that is treated as a )usiness -inventory. instead of as an
investment
<xamples could include#
In ro(n v" Comr, +=3 1",d =5> -*th Cir" +4==., the exempt taxpayer o(ned *?? acres of
unimproved land used for gra&ing purposes (ithin its tax-exempt mission" !axpayer decided to sell
the land and listed it (ith a real estate )ro'er" !he exempt organi&ation instructed the )ro'er to
su)divide the land into lots and develop it for sale" !he )ro'er had the land plotted and laid into
su)divisions (ith several lots" Streets (ere cleared, graded and shelled@ storm se(ers (ere put in
at street intersections@ gas and electric lines (ere constructed@ and a (ater (ell (as dug" <ach
year ,? to 3? properties (ere sold" !he court held that the taxpayer (as holding lots for sale to
customers in the regular course of )usiness" !he court identified the sole 6uestion for its
determination as (hether the taxpayer (as in the )usiness of su)dividing real estate" !he fact that
the taxpayer did not )uy additional land did not prevent the court from finding that the sales
activities resulted in an active trade or )usiness"
In 1arley v" Comr", A !"C" +4> -+4=5., the taxpayer sold ,* lots out of a tract of land previously
used in his nursery )usiness )ut no( more desira)le as residential property" ecause the taxpayer
made no active efforts to sell and did not develop the property, the court descri)ed the sale as /in
the nature of the gradual and passive li6uidation of an asset"0 !herefore, the income derived from
the sales represented capital gains income, rather than ordinary income from the regular course of
)usiness as in the ro(n case"
Dispositions of several thousand acres of land )y a school over a period of t(enty-five years does
not constitute sale of land held primarily for sale to customers in the ordinary course of )usiness
and thus gains are excluda)le under Internal Revenue Code Section *+,-).-*. -Briv" Ltr" Rul"
45+4?54 -1e)" +3, +445.."
Developing or su)dividing land and selling a large num)er of homes or tracts of land from that
development in a given period"
uying a property$home reha))ing it and then selling it immediately thereafter (hen this (as your
sole intent -note# !he activity must manifest a fre6uency and continuity, and are pursued in a
manner generally similar to compara)le commercial activities of nonexempt organi&ations." It is
unclear (hether the purchase and sale of one or t(o homes in a given year that (ere held for
investment purposes (ould trigger U!I"
Blease contact one of our Self Directed IRA <xperts at >??-=A,-?5=5 for more information"
WATSON v. COMMISSIONER, 345 U.S. 544 (1953)
345 U.S. 544
WATSON ET AL. v. COMMISSIONER OF INTERNAL REVENUE.
CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE NINTH CIRCUIT.
No. 29.
A!"#$% F$&!#'!( 2, 1953.
D$)*%$% M'( 1+, 1953.
For several years, a taxpayer held an undivided interest in an orange grove and engaged in the business of growing
and selling the oranges it produced. In the midst of the 1944 growing season, she sold her interest in the grove,
including an unmatured crop then on the trees. Held For federal income tax purposes, under 11! "#$ of the Internal
%evenue &ode, as in effect in 1944, she must treat that part of her profit from the sale which is attributable to the
unmatured crop as ordinary income ' not as a capital gain. (p. )4)'))*.
"a$ It is immaterial that, under the law of the state where the land is situated, an unmatured, unharvested crop is
treated as real property for many purposes. (. ))1.
"b$ In the circumstances of this case, the proceeds of the sale fairly attributable to the crop were derived from
property +held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business,+
within the meaning of 11! "#$, as it existed in 1944. (p. ))1')),.
19! F.,d )-, affirmed.
.he .ax &ourt sustained a deficiency assessed by the &ommissioner of Internal %evenue against petitioners, but
reduced the amount. 1) .. &. /00. .he &ourt of 1ppeals affirmed. 19! F.,d )-. .his &ourt granted certiorari. *44
2.3. /9) . 1ffirmed, p. ))*.
1rthur 4c5regor argued the cause for petitioners. 6ith him on the brief was 1. &alder 4ac7ay.
8llis 9. 3lac7 argued the cause for respondent. 6ith him on the brief were 3olicitor 5eneral &ummings, 1ssistant
1ttorney 5eneral :yon and Hilbert (. ;ar7y. <*4) 2.3. )44, )4)=
&hester H. Ferguson and 5eorge 6. 8ric7sen filed a brief for 8dwards et al., as amici curiae, supporting petitioners.
4%. >23.I&8 ?2%.@9 delivered the opinion of the &ourt.
.his case relates to a taxpayer who, for several years, held an undivided interest in an orange grove and engaged in
the business of growing and selling the oranges it produced. In the midst of the 1944 growing season, she sold her
interest in the grove, including an unmatured crop then on the trees. .he Auestion before us is whether, for federal
income tax purposes, she must treat that part of her profit from the sale which is attributable to the unmatured crop
as ordinary income or as a capital gain. For the reasons hereafter stated, she must treat it as ordinary income.
In 1944, 4rs. 4. 5ladys 6atson, one of the petitioners here, and her two brothers, each owned an undivided one'
third interest in a 110'acre navel orange grove near 8xeter, .ulare &ounty, &alifornia. Its management had been
supervised by her brothers since 191, and, since 194,, she and her brothers had operated it as a partnership. It was
the oldest and one of the best groves in the locality. Its production per acre was about twice the average of such
production in the county. In each of the last five years the value of its crop had increased over that of the year
before. In 194* it produced !9,/)1 loose boxes of oranges, yielding a gross income of B1*-,/0/.!1. 1fter deducting
all expenses of cultivation, operation, pic7ing and hauling, a net income of B9,,1)*.0) was left. 1 1nticipating a
heavy frost after 9ovember, <*4) 2.3. )44, )4-= 1944, one of the brothers advocated selling the grove before then.
1ccordingly, in 4ay or >une, it was offered for B19!,100, complete, including land, trees, unmatured crop,
improvements, eAuipment and a five'acre peach orchard. 1t about that time the 1944 orange crop was in bloom.
?y >uly the smaller fruit had dropped from the trees and the crop was +set,+ but not assured. 1 purchaser became
interested but delayed his decision so as to determine more accurately the probable crop and to cause the sellers to
bear more of the expense of its care. He examined past production records and, by early 1ugust, received estimates
that the 1944 crop might be from !0,000 to /0,000 boxes, which, at current prices, would bring him B1,0,000 for
the crop above expenses. @ne of 4rs. 6atsonCs brothers also estimated the 1944 crop at !0,000 boxes if it matured.
1ugust 10, the sales price of B19!,100 was agreed upon, payable B10,000 in cash and the balance 3eptember 1. 9o
allocation of the price between the crop and the rest of the property was specified but the seller bore the expense of
caring for the crop up to 3eptember 1, amounting to B1-,0,0.)4. .he sale was carried through and there was no
serious frost. .he crop filled !4,,-/ boxes. .he purchaser sold them for B14-,000, yielding him a net return of
B1,-,000.
4rs. 6atson filed a #oint return with her husband, ta7ing full deductions for her one'third share of all of the
business expenses incurred in the cultivation of the crop, but treating her gain from the sale of the grove, including
the unmatured crop, as a long'term capital gain. @n that basis, her net gain from the sale of the grove was shown as
B4/,/19./,, but, treating it as a long'term capital gain, only )0D of it, or B,4,409.91, was included in her taxable
income. , <*4) 2.3. )44, )4!=
.he &ommissioner of Internal %evenue assessed a deficiency against petitioners, largely based on his claim that
whatever part of 4rs. 6atsonCs income was attributable to the unmatured crop should be treated as ordinary
income. He allocated B1,,,)00, out of the B19!,100 received for the grove, as attributable to the unmatured crop.
@n that premise, he assessed a deficiency of B,4,101.*) against petitioners on their #oint return. @n review, the .ax
&ourt, with two #udges dissenting, sustained the &ommissioner in principle but reduced to B40,000 the portion of
the proceeds attributable to the crop. 1) .. &. /00. 6ith other ad#ustments, not material here, the .ax &ourt
reduced the deficiency to B-,9,0.*). .he &ourt of 1ppeals affirmed. 19! F.,d )-. In the meantime, the .ax &ourt
made comparable decisions in 4c&oy v. &ommissioner, 1) .. &. /,/, and @wen v. &ommissioner, ('H .& 4emo,
)0,*00, each of which was reversed on appeal, 19, F.,d 4/- "&. 1. 10th &ir.$, and 19, F.,d 100- "&. 1. )th &ir.$.
3hortly before the latter decisions, the %evenue 1ct of 19)1 amended the statute in relation to taxable years
beginning after Eecember *1, 19)0, to permit proceeds from certain sales of unharvested crops to be treated as
capital gains. * 6e granted certiorari in the instant case to resolve the above'indicated conflict of statutory
construction still affecting many sales made before 19)1. *44 2.3. /9) .
.he issue before us turns upon the 1cts of &ongress. In 19)1, &ongress, for the first time, dealt expressly and
specifically with this sub#ect. 4 6hile that action was <*4) 2.3. )44, )4/= prospective only, its terms throw light on
the problems of prior years. ) .he adoption of that amendment emphasiFed the point that the Auestion was one of
federal law. Its adoption also recogniFed that, in order for such income to be a capital gain, an affirmative statement
by &ongress was needed. Finally, it not only permitted proceeds of unharvested crops to be treated as capital gains
under certain circumstances, but it provided that, under those circumstances, the taxpayer could not deduct from
his taxable income the expenses attributable to the production of the unharvested crop. .hose expenses thereafter
must be treated as capital investments added to the basis of the property to which they relate. .his emphasiFes the
impropriety of the interpretation advocated by 4rs. 6atson in the instant case. 3he see7s to deduct her share of the
crop cultivation expenses at 100D up to the date of the sale. 1t the same time, she <*4) 2.3. )44, )49= claims a
right to report only )0D of her gain on the sale of those crops to which the cultivation expenses relate. -
In the instant case, we are dependent upon 11! "#$ of the Internal %evenue &ode, as in effect in 1944. !.he <*4) 2.3.
)44, ))0= controlling language in that subsection then reAuired that, in order for gains from the sale of property to
be treated as capital gains, the property sold must be +used in the trade or business+ of the taxpayer, +held for more
than - months,+ and not +held by the taxpayer primarily for sale to customers in the ordinary course of his trade or
business.+ In the instant case, the &ommissioner contends that, while the land and trees met these and all other
tests of the subsection, the unmatured, unharvested crop of oranges met none of the above three.
8ach day brought the annual crop closer to its availability for sale in the ordinary course of that business. 6hile the
uncertainty of its condition at maturity discounted its current value, nevertheless, its presence contributed
substantially to the value of the grove. .he &ommissioner allocated to the unmatured crop, as of 3eptember 1, a
value of B1,,,)00 out of the B19!,100. .he .ax &ourt reduced this to B40,000. 6e accept the latter amount now
confirmed by the &ourt of 1ppeals. It is obvious that the parties to this sale did in fact attribute substantial value to
the unmatured crop. If, at any moment, the crop had been stripped from the trees or destroyed by frost, there would
have resulted at once a substantial reduction in the sales value of the grove. <*4) 2.3. )44, ))1=
1ssuming B40,000 to be the value fairly attributable to the presence of the crop in 1ugust and 3eptember, 1944, it
remains for the taxpayer to demonstrate that 11! "#$ has authoriFed that value, in addition to the value of the land,
trees, improvements and eAuipment, to be treated as a capital gain.
4rs. 6atson and the &ourts of 1ppeals for the Fifth and .enth &ircuits have placed emphasis upon a claim that,
under the law of the state where the land is situated, an unmatured, unharvested crop, for many purposes, is treated
as real property. 6e regard that as immaterial. 6hether or not the crop be real property, the federal income tax
upon the gain resulting from its sale is, in its nature, a sub#ect of federal law.
.he &ommissioner urges two grounds in support of his position that 11! "#$ does not authoriFe the taxpayerCs
treatment of the proceeds of the unmatured crop as a capital gain. .he first is that the proceeds fairly attributable to
the crop are derived from property held by the taxpayer primarily for sale to customers in the ordinary course of the
taxpayerCs trade or business. 6e agree with that contention. 1lthough the property was not severable at the date of
its sale, there is nothing in the 1ct reAuiring it to be severable. 6hile, in previous years, li7e crops were held for a
sale that occurred after maturity, in 1944 the date of that sale came 3eptember 1. .here is nothing in the 1ct that
distinguishes between the taxable character of a gain derived from a present sale discounting the haFards of the
future, and one derived from a later sale when the haFards are past. 1fter the transfer of title to the grove, the crop
on the trees retained its character and continued to be held for sale to customers of the grove owner in the ordinary
course of the ownerCs trade or business.
.he &ommissionerCs treatment of the proceeds of sales of unmatured crops as ordinary income in the absence
of <*4) 2.3. )44, )),= a statutory reAuirement to the contrary is consistent with the policy evidenced in 6illiams
v. 4c5owan, 1), F.,d )!0,)!,, which established in the 3econd &ircuit, in 194), the doctrine that +upon the sale of
a going business it <the sales price= is to be comminuted into its fragments, and these are to be separately matched
against the definition in 11! "a$ "1$ . . . .+ It is consistent also with the policy of the ?ureau of Internal %evenue and
the .ax &ourt, dating, at least, from the statement made by the ?ureau in 194-, that, under circumstances
comparable to those before us, +regardless of their stage of development, any gain realiFed from the sale of growing
crops is ordinary income.+ /
6e do not have here the situation which arises from the sale of land, including coal or other mineral wealth not
separated from its natural state and not in the course of annual growth leading to a seasonal separation. 3ee ?utler
&onsolidated &oal &o. v. &ommissioner, - .. &. 1/*. .he instant case also is distinguishable from that of growing
timber which is not in itself an annual or short'term product. 3ee &arroll v. &ommissioner, !0 F.,d /0-G <*4) 2.3.
)44, ))*= &amp 4anufacturing &o. v. &ommissioner, * .. &. 4-!.
Having reached this conclusion, we find it unnecessary to pass upon the &ommissionerCs second contention that,
because the crop did not come into existence before it was +set+ in >uly, or at least before it was in bloom in 4ay or
>une, it had not been held by 4rs. 6atson for more than six months at the time of its sale.
1ccordingly, the #udgment of the &ourt of 1ppeals is
1ffirmed.
Foo,-o,$.
< Footnote 1 = In 194, it yielded )4,9*9 boxes with a gross income of B/,,),1.1! and a net of B49,!90.10. Its average
annual yield from 19*4 to 194* was )),09! boxes with a gross income of B4-,)1,.-/ and a net of B,,,141.4,.
< Footnote , = 11! "b$ and "c$ ",$, I. %. &., as amended by 1)0 "c$ of the %evenue 1ct of 194,, c. -19, )- 3tat. /4*'
/44, ,- 2.3.&. "1940 ed., 3upp. H$ 11! "b$ and "c$ ",$.
< Footnote * = -) 3tat. )00')01, ,- 2.3.&. "3upp. H$ 11! "#$, ,4 "f$, 11* "b$ "1$.
< Footnote 4 = .he %evenue 1ct of 19)1 added to 11! "#$ of the Internal %evenue &ode +"*$ 31:8 @F :19E 6I.H
29H1%H83.8E &%@(. ' In the case of an unharvested crop on land used in the trade or business and held <*4)
2.3. )44, )4/= for more than - months, if the crop and the land are sold or exchanged "or compulsorily or
involuntarily converted as described in paragraph ",$$ at the same time and to the same person, the crop shall be
considered as Iproperty used in the trade or business.C+ -) 3tat. )00, ,- 2.3.&. "3upp. H$ 11! "#$ "*$. 1nd, eAually
important, it added to ,4 of the Internal %evenue &ode +"f$ 31:8 @F :19E 6I.H 29H1%H83.8E &%@(. '
6here an unharvested crop sold by the taxpayer is considered under the provisions of section 11! "#$ "*$ as
Iproperty used in the trade or business,C in computing net income no deduction "whether or not for the taxable year
of the sale and whether for expenses, depreciation, or otherwise$ attributable to the production of such crop shall be
allowed.+ Id., at )01, ,- 2.3.&. "3upp. H$ ,4 "f$.
< Footnote ) = .he purpose of &ongress to ma7e this amendment prospective, rather than retroactive, is emphasiFed
in the very next section of the 19)1 1ct. .hat section made retroactive to 194, another amendment to 11! "#$. It
redefined capital gains so as to include the proceeds of certain sales of livestoc7, provided such stoc7 be held for
draft, breeding or dairy purposes. 3toc7 so held is comparable to the orange trees rather than to the orange crop in
the instant case.
< Footnote - = In this connection, the 3enate &ommittee on Finance, when reporting the proposed amendment in
19)1, said +Jour committee believes that sales of land together with growing crops or fruit are not such transactions
as occur in the ordinary course of business and should thus result in capital gains rather than in ordinary income.
3ection *,* of the bill so provides. +Jour committee recogniFes, however, that when the taxpayer 7eeps his accounts
and ma7es his returns on the cash receipts and disbursements basis, the expenses of growing the unharvested crop
or the unripe fruit will be deducted in full from ordinary income, while the entire proceeds from the sale of the crop,
as such, will be viewed as a capital gain. 1ctually, of course, the true gain in such cases is the difference between that
part of the selling price attributable to the crop or fruit and the expenses attributable to its production. .herefore,
your committeeCs bill provides that no deduction shall be allowed which is attributable to the production of such
crops or fruit, but that the deductions so disallowed shall be included in the basis of the property for the purpose of
computing the capital gain. +.he provisions of this section are applicable to sales or other dispositions occurring in
taxable years beginning after Eecember *1, 19)0. +.he revenue loss under this provision is expected to be about B*
million annually.+ 3. %ep. 9o. !/1, /,d &ong., 1st 3ess. 4!'4/.
< Footnote ! = Internal %evenue &ode, as amended, )- 3tat. /4- +38&. 11!. &1(I.1: 51I93 19E :@3383. . . . . .
+"#$ 51I93 19E :@3383 . . . F%@4 .H8 31:8 @% 8K&H1958 @F &8%.1I9 (%@(8%.J 238E I9 .H8 .%1E8
@% ?23I9833. ' +"1$ E8FI9I.I@9 @F (%@(8%.J 238E I9 .H8 .%1E8 @% ?23I9833. ' +For the purposes of
this subsection, the term Iproperty used in the trade or businessC means property used in the trade or business, of a
character which is sub#ect to the allowance for depreciation provided in section ,* "l$, held for more than - months,
and real property used in the trade or business, held for more than - months, which is not "1$ property of a 7ind
which would properly be includible <*4) 2.3. )44, ))0= in the inventory of the taxpayer if on hand at the close of
the taxable year, or "?$ property held by the taxpayer primarily for sale to customers in the ordinary course of his
trade or business. +",$ 5898%1: %2:8. ' If, during the taxable year, the recogniFed gains upon sales or exchanges
of property used in the trade or business . . . exceed the recogniFed losses from such sales, exchanges, and
conversions, such gains and losses shall be considered as gains and losses from sales or exchanges of capital assets
held for more than - months. If such gains do not exceed such losses, such gains and losses shall not be considered
as gains and losses from sales or exchanges of capital assets. . . .+ "Italics supplied.$ 3ee ,- 2.3.&. 11! "#$.
< Footnote / = +.he production of fruit from orchards or groves constitutes a business, and section 11! "#$ of the
&ode, supra, is applicable to the sale of an orchard or grove. .he crops are produced with the primary purpose of
selling the fruit to customers in the ordinary course of the business. .herefore, regardless of their stage of
development, any gain realiFed from the sale of growing crops is ordinary income. +In view of the foregoing, it is
held that, for Federal income tax purposes, where citrus groves are sold with fruit on the trees, a portion of the
selling price must be allocated to the fruit and the balance to the land and trees. 5ain from the sale of the fruit will
constitute ordinary income. 5ain from the sale of the land and trees may be treated as capital gain under section 11!
"#$ of the Internal %evenue &ode, provided the recogniFed gains from all transactions coming within the purview of
that section exceed the recogniFed losses thereunder.+ 194-', &um. ?ull. *1.
4%. >23.I&8 4I9.@9, with whom 4%. >23.I&8 %88E and 4%. >23.I&8 E@25:13 #oin, dissenting from the
&ourtCs opinion and #udgment.
.he Auestion is 3hould the sale and conveyance of this land for a lump sum be treated wholly as a sale of real estate
taxable as a long'term capital gain, or should the crop of immature oranges be segregated and its value taxed as
ordinary incomeL
.he pertinent provisions of the statute are set forth in the margin. 1 4rs. 6atson does not contend that the growing
oranges were capital assets as defined in 11! "a$, but instead she claims that they were +property used in the trade or
business+ as defined in 11! "#$ and that she is entitled to capital gains treatment under that section. <*4) 2.3. )44,
))4= Her claim rests on her contention that the growing oranges were "1$ real propertyG ",$ used in her trade or
businessG and "*$ held for more than - monthsG and that they were neither "4$ properly includible in inventoryG nor
")$ held primarily for sale to customers in the ordinary course of her business.
First. .he immature oranges were real property when the orange grove was sold. 4rs. 6atson and her brothers sold
the green oranges as part of the land, without severance, constructive or otherwise. How this transaction should be
treated under &alifornia law does not necessarily control its treatment taxwise under the federal statute. ?urnet v.
Harmel, ,/! 2.3. 10*, 110 . However, real property is not defined in the %evenue 1ct, <*4) 2.3. )44, )))= and in
the absence of such definition we must loo7 to the law of &alifornia to determine what is real property. 2nder that
law, this crop of oranges passed as real estate. 6ilson v. 6hite, 1-1 &al. 4)*, 4-0, 119 (. /9), /9/G Joung v. ?an7 of
&alifornia, // &al. 1pp. ,d 1/4, 1/!'1//, 19/ (.,d )4*, )4)')4-. .he immature fruit, from the falling of the
blossoms until the harvesting, is a part of the realty, as its very existence and growth are wholly dependent upon the
ground from which it ta7es its life and gains its sustenance. 1ctually severed from the ground before maturity, the
fruit is worthless. Its life, and hence its value, lies in the soil of which it is a part.
3econd. .he &ommissioner urges that, unli7e the trees, the oranges are the ultimate product of the enterprise, and
as such are not +used+ in the business. 6e do not interpret the word +used+ so narrowly. 6e believe that the phrase
+used in the trade or business+ is simply designed to differentiate business assets from the taxpayerCs personal
assets and his nonbusiness, income'producing property. It is not disputed that 4rs. 6atsonCs business was raising
and selling oranges nor that the land and orange trees were used in her business. 1t the time the orange grove was
sold, the oranges were as much a part of the trees as the leaves and the bar7. .herefore, the oranges were +property
used in <4rs. 6atsonCs= trade or business.+
.hird. 6ere the oranges +held for more than - months+ before the saleL It is clear that the land and trees had been
held since >anuary 1, 194,, over two and one'half years prior to the sale. 1s we have #ust said, the oranges were real
property, an integral part of the trees on which they grew. .herefore, the holding period for the oranges is the same
as for the trees, and the oranges were +held for more than - months+ within the meaning of 11! "#$.
Fourth. .he ?ureau itself has said that the growing oranges were not +properly . . . includible in <4rs.<*4) 2.3. )44,
))-= 6atsonCs= inventory.+ .he ?ureauCs ruling provides in pertinent part
+6hile farmers may report their gross income upon the accrual basis "in which an inventory to determine profits is
used$, they are not permitted to inventory growing crops for the reason that the amount and value of such crops on
hand at the beginning and end of the taxable year can not be accurately determined. . . .+ ,
Fifth. 6e believe that the growing oranges were not +held . . . primarily for sale to customers in the ordinary course
of <4rs. 6atsonCs= trade or business.+ 6hat was the business of the taxpayerL 3he was in the business of raising and
selling matured fruit. 3he was not in the business of selling land and trees and green fruit growing upon the trees.
3he was going out of the business in which she had long been engaged. 3he sold everything for one lump sum,
without any allocation to land, trees or green fruit. It was not an ordinary business transaction. It was an
extraordinary transaction. It was not a sale in the ordinary course of business. It was a sale out of the course of
business for the purpose of going out of business. It was not a sale to an ordinary customer, who bought ripe fruit in
Auantities less than the whole crop, as 4rs. 6atson had been accustomed to sell them. It was a sale of land and
green fruit to one not a customer. 4rs. 6atson did not split the sale up into land, trees, and green fruit. 3he sold all
as one, and at the same time. It is the &ommissioner who brea7s up her sale into parts and ma7es something out of
it different from what it was, and then proceeds to tax the transaction as he remade it. I have always understood
that tax laws deal with realities. It is unrealistic to treat an <*4) 2.3. )44, ))!= extraordinary sale for one
consideration of real property, part of which is immature green fruit, which sale will put the seller completely out of
business, as an ordinary sale in the course of trade or business, when the business being closed out had been one
that dealt only in the sale of matured fruit. .he &ommissioner is not free to rema7e the transaction as he sees fit.
.he .enth &ircuit and the Fifth &ircuit have reached a different conclusion from that of the .ax &ourt and the 9inth
&ircuit in the instant case. In 4c&oy v. &ommissioner, 19, F.,d 4/- "&. 1. 10th &ir.$, the court was dealing with the
sale of land with a growing crop of wheat upon it. In @wen v. &ommissioner, 19, F.,d 100- "&. 1. )th &ir.$, as in the
instant case, the court was dealing with the sale of an orange grove. 4oreover, two Eistrict &ourts have held that the
seller of an orange grove is entitled to capital gains treatment of the value of the immature oranges. &ole v. 3myth,
9- F. 3upp. !4)G Irrgang v. Fahs, 94 F. 3upp. ,0-. I agree with these courts that the oranges in the instant case were
+property used in <4rs. 6atsonCs= trade or business+ as defined by the %evenue 1ct. .he sale of the orange grove
was not to be bro7en up to enable the &ommissioner to tax as personalty that which was real property. .he
immature crop of green oranges was not property held primarily for sale to customers in the ordinary course of
trade or business.
In amending the %evenue 1ct of 19)1, &ongress too7 cogniFance of the construction placed on 11! "#$ "1$ by the
&ommissioner and the .ax &ourt, and amended the section to ma7e it abundantly clear that unharvested crops
were a part of the realty upon which they were growing and were to be given capital gains treatment. -) 3tat. )00,
,- 2.3.&. "3upp. H$ 11! "#$ "*$.
1fter discussing the conflict that had arisen over the &ommissionerCs interpretation of the statute as to
growing <*4) 2.3. )44, ))/= immature crops, the 3enate &ommittee %eport on this 1mendment states
+Jour committee believes that sales of land together with growing crops or fruit are not such transactions as occur
in the ordinary course of business and should thus result in capital gains rather than in ordinary income . . . .+ *
&ongress was correcting a misinterpretation of the %evenue 1ct by the &ommissioner and the .ax &ourt. It was
ma7ing clear what the &ommissioner and the .ax &ourt had obfuscated. I see no reason why we should strain to
uphold a tax which &ongress has by recent legislation determined to be incorrect.
I would reverse the #udgment.
< Footnote 1 = +38&. 11!. &1(I.1: 51I93 19E :@3383. +"a$ E8FI9I.I@93. ' 1s used in this chapter ' +"1$
&1(I.1: 1338.3. ' .he term Icapital assetsC means property held by the taxpayer "whether or not connected with
his trade or business$, but does not include stoc7 in trade of the taxpayer or other property of a 7ind which would
properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by
the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or property, used in the
trade or business, of a character which is sub#ect to the allowance for depreciation provided in section ,* "l$ . . . or
real property <*4) 2.3. )44, ))4= used in the trade or business of the taxpayer . . . .+ )* 3tat. )0, as amended, ,-
2.3.&. 11! "a$ "1$. . . . . . +"#$ 51I93 19E :@3383 F%@4 I9H@:29.1%J &@9H8%3I@9 19E F%@4 .H8 31:8
@% 8K&H1958 @F &8%.1I9 (%@(8%.J 238E I9 .H8 .%1E8 @% ?23I9833. ' +"1$ E8FI9I.I@9 @F
(%@(8%.J 238E I9 .H8 .%1E8 @% ?23I9833. ' +For the purposes of this subsection, the term Iproperty used
in the trade or businessC means property used in the trade or business, of a character which is sub#ect to the
allowance for depreciation provided in section ,* "1$, held for more than - months, and real property used in the
trade or business, held for more than - months, which is not "1$ property of a 7ind which would properly be
includible in the inventory of the taxpayer if on hand at the close of the taxable year, or "?$ property held by the
taxpayer primarily for sale to customers in the ordinary course of his trade or business. +",$ 5898%1: %2:8. ' +If,
during the taxable year, the recogniFed gains upon sales or exchanges of property used in the trade or business . . .
exceed the recogniFed losses from such sales, exchanges, and conversions, such gains and losses shall be considered
as gains and losses from sales or exchanges of capital assets held for more than - months. If such gains do not
exceed such losses, such gains and losses shall not be considered as gains and losses from sales or exchanges of
capital assets. . . .+ )- 3tat. /4-, ,- 2.3.&. 11! "#$.
< Footnote , = I'1 &um. ?ull. !,.
< Footnote * = 3. %ep. 9o. !/1, /,d &ong., 1st 3ess. 4!. <*4) 2.3. )44, ))9=
U-*,$% S,',$. Co#!, o/ A00$'1.,F$%$!'1 C*!)#*,.
I.2'$1 DEL3ADO, P$,*,*o-$!, v. OFFICE OF PERSONNEL MANA3EMENT,
R$.0o-%$-,.
No. 2943254.
44 5'-#'!( 6, 21
?efore 986419, :@2%I8, and :I99, &ircuit >udges. Ismael Eelgado, of 4iami, F:, pro se. >ane &. Eempsey,
.rial 1ttorney, &ommercial :itigation ?ranch, &ivil Eivision, 2nited 3tates Eepartment of >ustice, of 6ashington,
E&, for respondent. 6ith her on the brief were .ony 6est, 1ssistant 1ttorney 5eneral, >eanne 8. Eavidson,
Eirector, and %eginald .. ?lades, >r., 1ssistant Eirector.
Ismael Eelgado appeals from the final decision of the 4erit 3ystems (rotection ?oard "M?oardN$ reversing the initial
decision of the administrative #udge "M1>N$ and affirming the @ffice of (ersonnel 4anagementCs "M@(4CsN$ decision
to terminate his disability retirement annuity on the basis that he had been restored to earning capacity. Eelgado
v. @ffice of (ers. 4gmt., 9o. 1.'/*14'0/'0/))'I'1 "4.3.(.?. 1pril 10, ,009$ "MInitial Eecision N$G Eelgado v.
@ffice of (ers. 4gmt., 11, 4.3.(.%. 4- ",009$ "MFinal @rder N$. 1lthough we find that EelgadoCs award of bac7 pay
constitutes income under the provisions of ) &.F.%. O /*1.1,09, we vacate for a determination in the first instance
whether the award of bac7 pay constitutes income in the year awarded or the year"s$ it would have been earned but
for EelgadoCs unwarranted suspension for the purposes of determining earning capacity pursuant to ) 2.3.&. O
/**!"d$.
?1&P5%@29E
In 19/!, Eelgado retired from the 2nited 3tates (ostal 3ervice due to disability, and received a disability retirement
annuity under the &ivil 3ervice %etirement 3ystem. He subseAuently wor7ed as a teacher, employed by the 4iami'
Eade 3chool ?oard. His salary as a teacher was less than /0 percent of the salary he would have received in his
former position, thus entitling him to continue receiving the annuity. In ,00/, following receipt of a report from
the 3ocial 3ecurity 1dministration, @(4 terminated EelgadoCs disability retirement annuity. @(4 found that
Eelgado had been restored to his earning capacity because EelgadoCs earned income for ,00- was B!,,!--.00, an
amount that exceeded /0 percent of the ,00- rate of pay of the position occupied by Eelgado immediately before
his retirement. .he @(4 further found that Eelgado had been wrongly paid his annuity for several months and
informed him of its intent to collect that overpayment.
Eelgado reAuested reconsideration on the basis that B4-,)*/.,/ of the B!,,!--.00 was received as the result of
litigation, following an unwarranted, indefinite suspension action ta7en against him by his former employer.
Eelgado argued that the money received as a result of litigation should not be considered part of his salary, as he
received it for a period of time during which he was not employed. 1s a result, Eelgado contended that his income
did not exceed /0 percent of the salary currently associated with the position he held directly before retirement,
that he was not restored to earning capacity, and that he was entitled to the continuation of his disability retirement
annuity. In 1ugust ,00/, @(4 issued a reconsideration decision affirming its termination of EelgadoCs disability
retirement annuity. @(4 reasoned that because the B4-.)*/.,/ was sub#ect to federal employment taxes "viF.,
3ocial 3ecurity and 4edicare taxes$, it constituted earned income.
Eelgado appealed the decision to the ?oard. .he 1> reversed the @(4Cs decision, finding that the bac7 pay award
constituted an Mamount received in court actions,N excluded from income pursuant to ) &.F.%. O /*1.1,09"f$, rather
than Mincome earned from personal wor7 efforts,N under ) &.F.%. O /*1.1,09"c$"*$. Initial Eecision at *'4.
@(4 appealed the initial decision, and the full ?oard reversed. In its decision, the ?oard determined that the
Mamount the appellant received as a result of litigation clearly constituted bac7 pay,N and was thus earned income
pursuant to ) &.F.%. O /*1.1,09"d$"1$"i$. Final @rder, 11, 4.3.(.%. at 49. In addition, the ?oard noted that the
amount received was sub#ect to federal employment taxes, which further indicated its nature as income pursuant to
) &.F.%. O /*1.1,09"c$"1$. .he ?oard further found that if the award was excepted as an Mamount< = received in
court actions,N it also met the exception to the court action exception for money received Min the course of trade or
business.N Final @rder, 11, 4.3.(.%. at 49')0, ) &.F.%. O /*1.1,09"f$. .he ?oard reasoned that the phrase Mtrade
or businessN was meant to relate to Mactivities focused on oneCs livelihood and earning a living,N and that the award
for bac7 pay was therefore received in the course of Eelgado earning his livelihood, because it was for services
Eelgado would have performed but for his improper, indefinite suspension. Id. at )0.
Eelgado timely appealed to this court. 6e have #urisdiction pursuant to ,/ 2.3.&. O 1,9)"a$"9$ ",00-$.
EI3&233I@9
.he scope of our review in an appeal from a ?oard decision is limited. 6e can only set aside the ?oardCs decision if
it was M"1$ arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with lawG ",$ obtained
without procedures reAuired by law, rule, or regulation having been followedG or "*$ unsupported by substantial
evidence.N ) 2.3.&. O !!0*"c$ ",00-$G see ?riggs v. 4erit 3ys. (rot. ?d., **1 F.*d 1*0!, 1*11 "Fed.&ir.,00*$.
Here, the facts are not disputed, and our review focuses on whether the ?oardCs actions were in accordance with
law.
Eelgado argues that the award of bac7 pay does not constitute MwagesN because it was not secured by personal wor7
efforts or services. %ather, it was an award resulting from a decision of the 3tate of Florida Eivision of
1dministrative Hearings that he had been improperly indefinitely suspended. Eelgado further contends that
3ocial 3ecurity payments were withheld from the payments by mista7e, and that no federal taxes should have been
withheld. Eelgado also argues that the ?oard failed to review the decision of the Florida 1dministrative :aw >udge
in ma7ing its determination.
.he government responds that the ?oardCs determination was in accordance with law, and properly relied upon
@(4Cs regulations in determining that the bac7 pay awarded to Eelgado constituted earned income. .he
government argues that, according to O /*1.1,09"c$ of the regulations, total income from all sources is used to
determine earning capacity, that this includes wages, and that any income sub#ect to federal employment taxes
constitutes earned income. Eelgado did not argue below that 3ocial 3ecurity was wrongfully withheld, and thus
the government contends that the argument is waived. .he government further points to section ) &.F.%. O
/*1.1,09"d$ for the proposition that MwagesN include bac7 pay. In addition, the government argues that the
decision in the Florida administrative hearing is not relevant, as it does not indicate the type of tax treatment that
should be given to the awarded bac7 pay.
6e agree with the government that bac7 pay, received as a result of an administrative proceeding, constitutes
income within the meaning of the regulations. .he governing statute states that M<i=f an annuitant receiving
disability retirement is restored to an earning capacity fairly comparable to the current rate of pay of the position
occupied at the time of retirement, payment of the annuity terminatesN and that M<e=arning capacity is deemed
restored if in any calendar year the income of the annuitant from wages or self'employment or both eAuals at least
/0 percent of the current rate of pay of the position occupied immediately before retirement.N ) 2.3.&. O /**!"d$.
.he implementing regulation explains that earning capacity Mis demonstrated by an annuitantCs ability to earn
post'retirement income in a calendar year through personal wor7 efforts or services,N before describing Mtwo
sources of income wages and self'employment income. 1ll income which is sub#ect to Federal employment taxes
"viF., 3ocial 3ecurity or 4edicare taxes$ constitutes earned income. In addition any other income as described in
this section also constitutes earned income.N ) &.F.%. O /*1.1,09"c$, "c$"1$. 3ubsection "d$ then defines the term
MwagesN as Mthe gross amount of all remuneration for services performed by an employee for his or her employer,
unless specifically excluded hereinN and states that wages include bac7 pay. ) &.F.%. O /*1.1,09"d$, "d$"1$"i$.
Finally, subsection "f$ lists income not considered in determining earning capacity, including Mamounts received in
court actions whether by verdict or settlement, unless received in the course of their trade or business.N ) &.F.%. O
/*1.1,09"f$"!$.
Eelgado was reinstated and awarded bac7 salary as a result of a state administrative proceeding. .he award of
bac7 pay was sub#ect to federal employment "3ocial 3ecurity$ taxes, and as a result, constitutes income for the
purposes of ) &.F.%. O /*1.1,09. Eelgado waived his argument that 3ocial 3ecurity taxes were wrongly withheld
from the award. 8ven if he had not, it is unclear why the money received would be exempt from federal
employment taxes, given that tax law generally treats bac7 pay awarded in litigation as wages for the purposes of
social security or other federal employment taxes. 3ee &.I.%. v. 3chleier, )1) 2.3. *,*, **0, 11) 3.&t. ,1)9, 1*,
:.8d.,d ,94 "199)$ "bac7 wages recovered under 1E81 settlement are not excludable income where the recovery
was not on account of personal in#ury or sic7ness$G see also 1brahamsen v. 2nited 3tates, ,,/ F.*d 1*-0, 1*-*'-4
"Fed.&ir.,000$ "exit incentives received pursuant to a settlement agreement constitute wages for the purposes of
federal employment taxes$. In any event, whether the bac7 pay award was properly sub#ect to federal employment
taxes is not an issue before us.
.he regulation further specifically states that bac7 pay is included in wages. ) &.F.%. O /*1.1,09"d$"1$"i$. 9or
does the award meet the exception of ) &.F.%. O /*1.1,09"f$"!$ for Mamounts received in court actions whether by
verdict or settlement.N .he administrative proceeding was not a court action. 4oreover, to the extent that there
is any conflict between the inclusion of bac7 pay and the exclusion of amounts received in court actions, the specific
enumeration of bac7 pay as constituting income clearly prevails over the general recitation of court actions,
particularly when it is doubtful here that the recovery from an administrative agency came from a court action.
1lthough we agree with the ?oard that the bac7 pay award constitutes income not exempt under subsection "f$
"!$, the ?oard did not explicitly determine for which year"s$ the award should be considered income for purposes of
determining earning capacity under ) 2.3.&. O /**!"d$ "viF., the year"s$ for which it was awarded or the year in
which it was awarded$. .hus, the Auestion remains open as to whether the amount of the bac7 pay is properly
counted as a measure of earning capacity in the year the award was made, when the bac7 pay includes an earlier
yearCs pay. Here, the regulation is ambiguous. For example, ) &.F.%. O /*1.1,09"c$")$ states that Mincome is
earned in the calendar year the annuitant actually renders the personal wor7 effort or service and either actually or
constructively receives the remuneration, except as provided under paragraph "c$"!$ of this section.N .he excepted
paragraph explains that for certain deferred compensation plans that defer the constructive receipt of income for
tax purposes, the income is not deferred for the purposes of determining earning capacity. ) &.F.%. O /*1.1,09"c$
"!$. %ather, that income is Mconsidered income in the calendar year in which the services are performed, even
though the Internal %evenue &ode may exclude <them= from income for tax purposes.N Id. .hese subsections are
consistent with ) &.F.%. O /*1.1,09"c$, which states that earning capacity is Mdemonstrated by an annuitantCs ability
to earn post'retirement income in a calendar year through personal wor7 efforts or services.N 1ll three of these
statements, ta7en together, evince an intent to loo7 at the ability of an annuitant to earn income in a given year,
presumably the year in which the wor7 was performed or would have been performed but for the suspension later
found unwarranted.
@n the other hand, section "c$ states that M<i=n determining an annuitantCs income for a calendar year, the following
considerations apply,N immediately following which subsection "1$ explains that M<t=here are two sources of income
wages and self'employment income. 1ll income which is sub#ect to Federal employment taxes constitutes earned
income.N ) &.F.%. O /*1.1,09"c$, "c$"1$. 2nder that reading, therefore, the regulation could fairly be said to include
in income Mfor a calendar yearN all income sub#ect to federal employment taxes in that year.
Following the above analysis, EelgadoCs bac7 pay award, if considered attributable to the year in which the wor7
would have been performed but for the unwarranted suspension, may well not have reached the /0 percent
threshold of ) 2.3.&. O /**!"d$. If, on the other hand, the award is attributable to the year in which it was
awarded, then EelgadoCs income would indeed have exceeded /0D of his previous income. .he ?oard did not
ma7e an explicit finding that the award to Eelgado constituted income in the year in which it was awarded, and
there is therefore no record on which we can review its determination. 3ee, e.g., 38& v. &henery &orp., *1/ 2.3.
/0, //, -* 3.&t. 4)4, /! :.8d. -,- "194*$.
1ccordingly, we vacate the ?oardCs decision and remand for further consideration in accordance with this opinion.
&@3.3
9o costs.
(8% &2%I14.