Kingsbury v. Commissioner ( 1976 )

Howard G. Kingsbury and Anna Z. Kingsbury, Petitioners v. Commissioner of Internal Revenue, Respondent

Kingsbury v. Commissioner

Docket No. 8444-72

United States Tax Court

65 T.C. 1068; 1976 U.S. Tax Ct. LEXIS 149;

March 3, 1976, Filed

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Decision will be entered under Rule 155.

In 1962 petitioner entered into an agreement with Mildred Sekyra, whereby petitioner took over the operation of a cardroom on premises owned by Sekyra. The agreement called for fixed monthly payments from petitioner to Sekyra. There was no formal assignment of Sekyra's license to operate the cardroom because any such assignment would have resulted in revocation of the license by county officials. In 1965 county officials determined that the 1962 agreement between petitioner and Sekyra was in fact an assignment of the license to operate a cardroom and, consequently, suspended the license. In January 1966 petitioner and Sekyra entered into a settlement agreement terminating their prior operating agreement. Under the settlement agreement petitioner was to receive a lump-sum payment of $ 14,000 plus 25 percent of the first $ 416,000 of the club's gross receipts in each year until February 1977.

1. Held: The 1962 agreement constituted a lease, the termination of which was a sale or exchange of property described in sec. 1231. Payments received pursuant to the settlement agreement were capital gains subject to recapture under sec. 1245 of depreciation taken with respect to the leasehold.

2. Held, further, amounts received pursuant to the settlement agreement are not subject to the self-employment tax.

3. Held, further, petitioner must include in income for 1966 the principal amount of a promissory note received in that year.

4. Held, further, petitioner realized commission income in 1966 in the amount of $ 2,042.

Horace N. Freedman and Stephen Solomon, for the petitioners.

Robert G. Martinell, for the respondent.

Irwin, Judge.

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IRWIN

Respondent determined deficiencies in petitioners' Federal income tax as follows:

Year	Amount
1966	$ 40,948.60
1967	1 35,905.73
1968	$ 25,405.00
1969	38,024.00

After concessions by the parties, the issues remaining for decision are as follows:

(1) The proper characterization of payments received upon the termination of an agreement which gave the petitioner husband the right to operate a cardroom.

(2) Whether amounts received pursuant to a settlement agreement are subject to the self-employment tax.

(3) Whether petitioners must include in income in 1966 the principal amount of a promissory note received in that year.

(4) Whether petitioners realized commission income in 1966 in the amount of $ 2,042.

FINDINGS OF FACT

Some of the facts have been stipulated and the stipulation of facts, together with the exhibits attached thereto, are found accordingly.

Petitioners Howard G. Kingsbury and Anna Z. Kingsbury, husband and wife, were legal residents of Canoga Park, Calif., at the time of the filing of the petition herein. Petitioners' joint returns for the years 1966, 1967, 1968, and 1969, based on the cash method of accounting, were timely filed with the District Director of Internal Revenue, Los Angeles, Calif., and/or the Internal Revenue Western Service Center, Ogden, Utah. Anna Z. Kingsbury is before the Court only because of having signed joint returns; "petitioner" will hereinafter refer to Howard G. Kingsbury.

The issues in this case arise in connection with petitioner's association with the Pass Club, a cardroom located in Ventura County, Calif. The Pass Club (hereafter the club), which was built in 1953, was originally owned and operated by Paul W. Coons. After Coons' death in 1954 his widow (now Mildred Sekyra and hereafter referred to as Sekyra) took over the operation of the club.

In 1958 the board of supervisors of Ventura County, Ventura, Calif., passed an ordinance, article 4, section 6141, prohibiting the operation of a cardroom. Section 6142 provided an exception to section 6141 for cardrooms which on the effective date of the ordinance were being operated pursuant to a valid cardroom license. Section 6143 provided: "Card room licenses in effect on the date of this ordinance are valid only for the place and operator stated in the license and shall not be transferred to any other place or person." Sekyra has, since before 1959, been licensed to operate a cardroom in Ventura County.

In April 1959, Sekyra hired Salvador Valdivia (hereafter Valdivia) to manage the Pass Club for a period of 5 years. Pursuant to a written agreement between Sekyra and Valdivia, Valdivia was to receive one-half of the net profits from the operation of the club. During the period that Valdivia managed the club, the gross receipts never exceeded $ 3,000 per month.

In 1961 the club was completely destroyed by fire. The insurance proceeds, approximately $ 18,000, were inadequate to cover the costs of reconstruction. Unable to secure financing elsewhere, Sekyra borrowed $ 30,000 from a personal acquaintance giving him a trust deed on the property as security. As construction on the new building progressed, however, Sekyra realized that she would need additional financing in order to reopen the club.

Petitioner, who had been a regular customer during the 2-year period preceding the fire, was approached by Valdivia as a possible source for the funds needed to complete the new building. Petitioner became interested in the possibility of working out an arrangement whereby he could take over the operation of the club. After conducting a survey of other cardrooms in the area, petitioner was convinced that the club could be a very profitable enterprise -- given some changes in its operation.

Sekyra was receptive to the idea of working out an arrangement with petitioner. She had not been entirely satisfied with Valdivia's work and she believed that petitioner was more qualified to direct the club's operation than either Valdivia or herself. Furthermore, Sekyra was in poor health and wanted to be free from the responsibilities of operating the club.

Both petitioner and Sekyra were aware that an outright assignment of the cardroom license to petitioner would result in the revocation of the license by county officials. Petitioner employed an attorney, Karl G. Kappel (hereafter Kappel), to represent him in the negotiations with Sekyra and to draft an agreement between them. At the conclusion of the negotiations, Kappel understood that petitioner and Sekyra wanted an arrangement whereby petitioner would take over the operation of the club and have full use and benefit of the license, together with the use and benefit of the premises, without technically violating the county ordinance which prohibited the transfer of the license. On February 26, 1962, petitioner and Sekyra entered into a written agreement, drafted by Kappel, which was entitled "Operating Agreement." Relevant portions of this agreement follow:

II

[Sekyra] ² does hereby hire * * * [petitioner] ³ exclusively to manage and operate the aforedescribed premises, its structures, and appurtenances under the aforedescribed license for a period of five (5) years from the date of this agreement under the terms and conditions as hereinafter set forth. * * * [Petitioner] does hereby accept said management under this Operating Agreement under the terms and conditions as hereinafter set forth for the term of five (5) years.

III

The parties hereto mutually agree that the compensation to each of the parties hereto shall be as follows:

[Sekyra] is to receive the first Two Thousand Dollars ($ 2,000.00) of the gross income in each and every month during the term of this agreement, beginning on the first day of the first month that said card club is open for business; that all other gross income in excess of Two Thousand Dollars ($ 2,000.00) is to be received by * * * [petitioner]. * * *

IV

[Sekyra] agrees that she will:

A. Build said building to completion as rapidly as possible and will as rapidly as possible complete all road work, parking area work, and appurtenances to said building, and will as rapidly as possible fixturize, furnish and equip said premises, and supply chips for the operation of said premises.

B. Maintain and insure where necessary said premises, including the building, road, and parking area.

C. Faithfully pay when due all mortgage payments, lease payments, taxes, assessments, and any other obligations on said land, structures, and improvements thereon, and furnishings, fixtures, and equipment therein.

V

[Petitioner] agrees that he will:

A. Pay to * * * [Sekyra] as further consideration for his rights under this Operating Agreement the sum of Seven Thousand Five Hundred Dollars ($ 7,500.00), payable one-half (1/2) upon the execution of this agreement and one-half (1/2) at the time the premises is completed so that he may actively take over as manager of said card club.

B. Carefully and honestly take care of the business conducted on said premises.

C. Pay from his portion of the gross income all operating expenses of said card club not heretofore agreed to be paid by * * * [Sekyra], including, but not limited to all employee taxes due Federal and State governments, all playing cards, linens, labor costs, license renewal fees, and breakage.

D. Keep the inside of said premises in good repair and maintenance, and carry and maintain adequate public liability insurance on the whole of said premises, for the benefit of both parties.

VI

* * *

E. * * * [Petitioner] shall have the sole and exclusive right to conduct the business on said premises subject to the terms of this agreement, and has the sole right to hire or fire any and all employees as he sees fit and proper.

F. Neither the premises nor the business conducted therein shall be used in such a manner as to violate the terms of this agreement, nor shall they be mortgaged or hypothecated in such a manner as to interfere with the operation of said business.

G. The rights and liabilities of this agreement shall terminate upon the death or total incapacity of * * * [petitioner], but on the death or total incapacity of * * * [Sekyra] the rights and liabilities under this agreement shall remain in full force and effect.

H. * * * [Petitioner] at his option may renew this Operating Agreement under the terms and conditions as herein stated for an additional period of Five (5) years, provided he gives written notice to * * * [Sekyra] sixty (60) days prior to its termination of his intentions to renew and provided he has performed all of the terms and conditions of this agreement on his part to be performed, and at the end of this period, another 5 years on the same terms and conditions.

* * *

J. Each of the parties hereto has other business activities and that neither is required to devote their full time and attention to said card club, but that each shall use his or her best efforts for the furtherance of the best interests of said business and to promote the welfare of said business operation.

K. The rights hereunder granted to each of the parties are exclusive and irrevocable except as hereinabove stated.

Pursuant to article V of the operating agreement, petitioner paid $ 7,500 to Sekyra in 1962 in exchange for his rights under the agreement.

When the Pass Club reopened in May 1962, petitioner assumed full responsibility for its operation. Although he employed a full-time manager, the major decisions remained within petitioner's control. The manager hired by petitioner, Norman C. McGinnis, had worked in the club from 1954 to 1960 and was familiar with its operation. Petitioner, therefore, delegated some of the more routine responsibilities to McGinnis.

The club contained eight card tables which could each accommodate eight players. The house did not participate in the playing of cards, but merely rented table space. Each player paid a fee every 30 minutes, which varied according to the stakes being played for at his table. Three employees were required to sell chips and collect table rent when the club was full. Whereas the original building had only a lunch counter, the new building contained restaurant facilities which could accommodate 40 people. When petitioner began operating the club, he made arrangements for the restaurant to be operated by Clarence Lopez, independently of the cardroom operation. Although Sekyra objected to this arrangement, it remained in effect during the entire period that petitioner was associated with the club.

Prior to petitioner's association with the Pass Club, the customers played primarily poker. Petitioner believed that the club could generate higher profits if it attracted customers who preferred to play the game panguingue (pan). People who played pan were generally more affluent than people who played poker. Petitioner shifted the emphasis from poker to pan hoping that a more affluent clientele would play for higher stakes, which would increase the club's profits since the table charge depended upon the stakes played for. The table charge was determined by petitioner.

The club grossed at most $ 36,000 annually prior to the time petitioner took over its operation, but the volume of business substantially increased under petitioner's direction, as illustrated by the following chart:

	Gross income	Net profits
	generated by	of the
	the Pass Club	Pass Club
Prior to petitioner's commencing the
operations of the Pass Club	$ 24,000 -- $ 36,000	(Unknown)
5/1/62 -- 12/31/62	71,481	$ 15,789
1/1/63 -- 12/31/63	179,709	55,334
1/1/64 -- 12/31/64	238,921	82,759
1/1/65 -- 11/10/65	320,014	125,698

Petitioner reported all of the gross income generated by the Pass Club and deducted all of the expenses incurred in its operation on his Federal income tax returns for the years 1962, 1963, 1964, and 1965. The payments which petitioner made to Sekyra were characterized as rental expense. During each of these years, Sekyra reported the payments she received from petitioner as rental income on her Federal income tax returns.

During the years petitioner was associated with the Pass Club, he invested the following amounts in connection with its operation:

Description	Amount	Year
Paid to Sekyra pursuant to article V of
the operating agreement	$ 7,500.00	1962
Purchase of certain kitchen equipment	4,023.30	1962
Purchase of certain card tables, chairs,
office furniture, and various other
improvements	3,507.02	1962
Miscellaneous purchases of equipment
and/or leasehold improvements	1,255.00	1963
Miscellaneous purchases of equipment
and/or leasehold improvements	4,402.55	1964
Miscellaneous purchases of equipment
and/or leasehold improvements	1,500.00	1965

Depreciation deductions were taken on petitioner's 1962, 1963, 1964, and 1965 returns with respect to the above items. Respondent audited the 1963 return and did not contest the depreciation deductions claimed for that year.

The terms of the operating agreement obligated petitioner to make monthly payments to Sekyra of $ 2,000. This amount was increased several times during the period that petitioner operated the club. By November 1965 petitioner was paying Sekyra $ 6,000 per month. Petitioner was under no obligation to increase the payments, but in light of the club's financial success he was willing to agree to Sekyra's periodic requests that the payments be increased. Petitioner never provided Sekyra with financial statements or other reports relating to the operation of the club.

While Sekyra had no official responsibilities relating to the club's operation, she originally tried to spend a few hours a day at the club. Due to ill health, however, her visits eventually declined in number and duration. When she was at the club she generally visited with the customers and sometimes played cards. She occasionally served as cashier and also occasionally sold chips.

Valdivia, who had been hired by Sekyra in 1959 to manage the club for 5 years, believed that the operating agreement between Sekyra and petitioner was a breach of his own contract with Sekyra. On July 25, 1963, Valdivia, Sekyra, and petitioner entered into an agreement whereby petitioner and Sekyra agreed to pay Valdivia $ 11,000 for the release of his rights under the contract he had with Sekyra. Petitioner paid the entire $ 11,000 to Valdivia in 1963 and deducted the entire amount of the payment as an ordinary and necessary business expense on his 1963 Federal income tax return. Respondent audited petitioner's 1963 return and disallowed the deduction to the extent of $ 5,500.

Sekyra personally renewed the cardroom license during each year that petitioner was operating the club. The licensing fee, however, was paid by petitioner.

On or about April 29, 1965, the district attorney for Ventura County rendered an opinion letter to the board of supervisors of Ventura County with respect to the ownership and operation of the Pass Club. The letter stated in part:

Pursuant to direction of the Board made on February 23, 1965, the District Attorney has investigated the ownership and operation of cardrooms to ascertain if any arrangements violate the intent of the cardroom ordinance enacted in 1958. * * *

The cardrooms which appear to have questionable ownership and operating arrangements are the Moorpark Rendezvous and the Pass Club. * * * In the Pass Club, a person named Kingsbury has contracted to operate the cardroom for the licensee, * * * [Sekyra], ⁴ and receives all of the money over a fixed amount (originally $ 2000 per month) which he pays to * * * [Sekyra].

* * *

The "Operating Agreement" entered into between * * * [Sekyra] and Howard Kingsbury appears to be more than just an employment contract. The agreement shifts responsibility for the cardroom operation to Howard Kingsbury and leaves * * * [Sekyra] more or less in the position of a landlady.

* * *

Paragraphs IV and V of the agreement are perhaps the most revealing provisions with respect to the relationship between * * * [Sekyra] and Howard Kingsbury. Howard Kingsbury undertakes to pay $ 7,500 for the "rights" he receives under the contract, to pay operating expenses out of his portion of the gross income, including employee taxes, playing cards, linens, labor costs, license renewal fees, and breakage, and to carry public liability insurance. * * * [Sekyra] undertakes the normal obligations of a landowner (e.g., paying taxes, mortgage payments and assessments) and the obligation of equipping the premises.

Paragraph VI-E states that Howard Kingsbury has "sole and exclusive right to conduct the business" and "to hire or fire any and all employees."

The conclusion that the contract effects a transfer of the license is further supported by the attempt by the parties to extend the rights of Howard Kingsbury beyond the lifetime of * * * [Sekyra] (Paragraph VI-G) and by the renewal rights of Howard Kingsbury continuing as "manager" for fifteen years at his own pleasure (Paragraph VI-H).

On the other hand, the parties to the contract explain that this contract was drafted for the purpose of obtaining financing to rebuild the premises. They state that as a matter of fact, the relationship between * * * [Sekyra] and Kingsbury has not been governed by the terms of the contract, and that * * * [Sekyra] has retained control of the operation.

A determination of what the actual arrangements are in regard to the operation of the Pass Club should be made by the Board of Supervisors after reviewing all of the evidence in the matter. If the Board determines that the arrangements were as indicated in the contract, then a conclusion could reasonably be drawn that the licensee has effected a transfer of the license in violation of the ordinance. The Board could then determine whether to revoke or suspend the license pursuant to the provisions of the ordinance.

The board of supervisors of Ventura County met at least twice to discuss possible violations of the county ordinances regarding the licensing of cardrooms. Both petitioner and Sekyra were aware that the county officials were conducting an investigation. Anticipating an adverse decision respecting the Pass Club, Sekyra attempted to dissolve the arrangement she had with petitioner by sending a letter, dated October 29, 1965, in which she stated:

This is to advise that your employment to manage and operate The Pass Club is hereby terminated owing to conduct detrimental to my business.

This is to advise further that I will assume all management and operational responsibilities and functions on November 1, 1965.

In a letter dated October 30, 1965, petitioner denied any conduct detrimental to the business and advised Sekyra that he planned to continue operating the club.

On November 1, 1965, Sekyra employed an attorney, Carl E. Ward, Jr. (hereafter Ward), to handle her legal problems stemming from the investigation. Ward requested petitioner to voluntarily disassociate himself from the club. Upon petitioner's failure to do so, Ward, upon behalf of Sekyra, filed a suit in the Ventura County Superior Court praying for a temporary restraining order and preliminary injunction restraining petitioner from managing or operating the Pass Club. The temporary restraining order was granted on November 10, 1965, and petitioner thereafter vacated the club and ceased all activities with respect to its operation.

The board of supervisors determined on November 16, 1965, that the operating agreement between petitioner and Sekyra was in violation of the county ordinance ⁵ prohibiting the transfer of a license to operate a cardroom. The board decided, however, to merely suspend Sekyra's license for a period of 60 days, provided that within the 60-day period the board be furnished proof that the operating agreement had been disposed of. In the absence of such proof the license would be permanently revoked.

Evidently both petitioner and Sekyra recognized, even before the board determination on November 16, 1965, that suspension of the license was likely. Prior to the board's determination, negotiations were already under way with a view to either modifying the operating agreement or terminating it completely and arriving at a financial settlement. Based on the board's determination and other informal indications from the county officials, Sekyra's attorney concluded that petitioner's association with the Pass Club should be completely terminated. A final settlement agreement, terminating the operating agreement, was reached on January 17, 1966. The settlement agreement provided in part:

Now, Therefore, * * * [Sekyra] ⁶ and * * * [petitioner] agree as follows:

1. The contract dated February 26, 1962, by and between * * * [Sekyra] and * * * [petitioner], and all oral modifications thereof, are terminated and * * * [petitioner] shall have no further rights, privileges, duties or liabilities by virtue of said contract or any or all modifications thereof, and * * * [Sekyra] shall have no further rights, privileges, duties or liabilities by virtue of said contract or any or all modifications thereof; and neither * * * [Sekyra] nor * * * [petitioner] shall have any further financial or monetary claim upon the other except as expressly set forth herein.

2. In consideration of this agreement * * * [Sekyra] shall make the following payments:

a. * * * [Sekyra] shall pay to * * * [petitioner] the sum of $ 14,000.00 as follows: the sum of $ 4,000.00 shall be paid on February 1, 1966; and the balance of $ 10,000.00, bearing interest at 6.5% per annum on the unpaid balance, shall be paid in monthly installments of $ 1,000.00 commencing on the first day of July, 1966, and continuing thereafter on the first day of each and every month until paid in full. Concurrently herewith * * * [Sekyra] will execute a promissory note in like terms and the obligation of * * * [Sekyra] to make the payments provided in this subparagraph a and in said promissory note shall inure to the benefit of * * * [petitioner's] heirs, assigns and/or successors. Said obligation shall not terminate upon the death of * * * [Sekyra].

b. * * * [Sekyra] shall forthwith pay the sum of $ 1,047.50 to Robert Shaw, attorney at law, as and for legal fees, and hereby absolves * * * [petitioner] and holds him harmless of any liability therefor.

c. Except as hereinafter provided, * * * [Sekyra] shall pay to * * * [petitioner] twenty-five percent (25%) of the first $ 416,000 of gross receipts resulting from the operation of the Pass Club as a licensed draw poker card club pursuant to the ordinances of the County of Ventura, State of California, in each and every calendar year until the 26th day of February, 1977. * * * [Petitioner] shall receive no percentage of any gross receipts in excess of $ 416,000 in any calendar year, and the maximum amount that he will be paid hereunder in any calendar year is $ 104,000. The obligation of * * * [Sekyra] to pay said twenty-five percent (25%) of the gross receipts hereunder shall be computed up to and including the day upon which any of the following events occurs, but shall not continue thereafter:

1. The death of * * * [Sekyra].

2. The death of * * * [petitioner].

3. The termination or revocation of the license now held by * * * [Sekyra] to operate a licensed draw poker card club on the premises known as the Pass Club, by any governmental agency.

Sekyra agreed to make the cash payment of $ 14,000 in response to petitioner's demand that he be paid $ 56,000 as reimbursement for property which he had purchased and which was to remain at the club. Sekyra and her attorney viewed the $ 14,000 as payment for such property to the extent of $ 10,000 and as a refund of the $ 6,000 monthly payment which petitioner made under the operating agreement in November 1965 to the extent of $ 4,000.

Petitioner claimed a deduction of $ 15,599.79 for a "loss of business property" on his 1965 return. An explanation accompanying the deduction indicated that the $ 15,599.79 represented petitioner's remaining basis in equipment and leasehold improvements retired by actual physical abandonment in November 1965 due to the closing of the Pass Club by county officials and the suspension of the club's operation by petitioner as owner. The return indicated that the deduction was taken pursuant to section 1.167(a)-8(a)(4), Income Tax Regs. Respondent did not disallow the deduction.

In 1966 petitioner received Sekyra's promissory note in the amount of $ 10,000, of which $ 7,000 was paid during that year. Petitioner also received in 1966 additional cash of $ 108,000 pursuant to the terms of the settlement agreement. In 1967 petitioner received $ 107,000, of which $ 3,000 was payment of the balance of the promissory note. In 1968 and 1969 petitioner received $ 92,043 and $ 115,975, respectively. Petitioner reported the amounts received from Sekyra during 1966, 1967, 1968, and 1969 as long-term capital gain. Respondent determined that all payments received by petitioner pursuant to the settlement agreement constituted ordinary income.

Sekyra has operated the Pass Club since petitioner left in November 1965. She has been assisted in this regard by McGinnis, who remained as manager and by her daughter who maintains the club's books and records.

During 1966 petitioner realized commission income in the amount of $ 2,042, which was not reported on the Federal income tax return filed for that year.

OPINION

Sekyra has, since before 1958, owned and been licensed to operate a cardroom known as the Pass Club in Ventura County, Calif. A county ordinance passed in 1958 prohibited the operation of cardrooms except with respect to cardrooms which on the effective date of the ordinance were being operated pursuant to an already existing valid license. Cardroom licenses in effect on the date of the ordinance remained valid only for the place and operator stated in the license and were made nontransferable. In 1962 Sekyra entered into a written agreement with petitioner whereby petitioner agreed to manage and operate the club for a period of 5 years. Petitioner had the right to extend the agreement for two additional 5-year terms. Under the written agreement petitioner agreed to pay Sekyra $ 7,500 at the outset and he also agreed to pay Sekyra the first $ 2,000 of the gross income generated by the club each and every month during the term of the agreement. Petitioner was to retain all gross income in excess of $ 2,000 per month. Under petitioner's direction the club generated gross income substantially in excess of $ 2,000 per month. During the period from May 1962 through November 1965 petitioner increased the amount of monthly payments to Sekyra so that by November 1965 he was paying her $ 6,000 per month.

In November 1965 the county board of supervisors determined that the agreement between Sekyra and petitioner was in violation of the ordinance prohibiting the transfer of a license to operate a cardroom. Sekyra's license was consequently suspended for a period of 60 days and she was admonished to terminate the agreement between petitioner and herself. In January 1966 Sekyra and petitioner entered into a settlement agreement terminating their prior operating agreement. Under the terms of the settlement agreement, petitioner was to receive a lump-sum payment of $ 14,000 plus 25 percent of the first $ 416,000 of gross receipts resulting from the operation of the club in each year until February 26, 1977.

1. Characterization of Payments Received Pursuant to the Settlement Agreement

The primary issue presented for our decision is the characterization of the payments received by petitioner, pursuant to the settlement agreement, during the years 1966, 1967, 1968, and 1969. Petitioner reported the payments as capital gains and urges the Court to endorse that characterization. In support of his position, petitioner maintains that in substance the operating agreement granted him a leasehold in the Pass Club. In petitioner's view this lease constituted depreciable property used in his trade or business, the cancellation of which, by virtue of the settlement agreement, produced capital gains under section 1231. Respondent, on the other hand, characterizes the payments as ordinary income received upon the cancellation of a contract to perform personal services. Respondent also maintains that regardless of the label placed upon petitioner's rights under the operating agreement, the termination of those rights did not constitute a sale or exchange as required under section 1231. Finally, respondent argues that even if there was a sale or exchange, petitioner's rights did not constitute property within the meaning of section 1231.

In order to prevail under section 1231 petitioner must establish that he sold or exchanged "property used in his trade or business," as that phrase is defined in section 1231(b). Section 1231(b) provides in part:

(b) Definition of Property Used in the Trade or Business. -- For purposes of this section --

(1) General rule. -- The term "property used in the trade or business" means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 6 months, and real property used in the trade or business, held for more than 6 months, which is not --

(A) property of a kind which would properly be includible in the inventory of the taxpayer if on hand at the close of the taxable year,

(B) property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, or

(C) a copyright, a literary, musical, or artistic composition, a letter or memorandum, or similar property, held by a taxpayer described in paragraph (3) of section 1221.

Petitioner must establish that his rights under the operating agreement: (1) Constituted property; (2) were used in his trade or business; (3) were subject to allowance for depreciation; and (4) were held by petitioner for more than 6 months.

We will consider first whether petitioner's rights constituted property within the meaning of section 1231. Contrary to petitioner's assertion that the term "property" does not have the same restrictive meaning for purposes of section 1231 as it does for purposes of section 1221 (relating to the definition of capital asset), the Supreme Court has concluded that property has exactly the same meaning for purposes of both sections. Commissioner v. Gillette Motor Co., 364 U.S. 130">364 U.S. 130 (1960). The question then becomes whether petitioner's bundle of rights under the operating agreement constituted a capital asset within the meaning of section 1221, disregarding the exclusion in section 1221(2). A right or bundle of rights may be considered property under State law and yet not be considered property for purposes of the capital gains provisions. Commissioner v. Gillette Motor Co., supra;Commissioner v. P. G. Lake, Inc., 356 U.S. 260 (1958). Generally a contract right to earn ordinary income in the future by the performance of personal services is not deemed a capital asset and any amount received for the transfer of such a right is treated as a substitute for ordinary income and is taxed accordingly. ⁷General Guaranty Mortgage Co. v. Tomlinson, 335 F. 2d 518 (5th Cir. 1964); United States v. Woolsey, 326 F. 2d 287 (5th Cir. 1963); Hyatt v. Commissioner, 325 F. 2d 715 (5th Cir. 1963), affg. a Memorandum Opinion of this Court; Bisbee-Baldwin Corp. v. Tomlinson, 320 F. 2d 929 (5th Cir. 1963); United States v. Eidson, 310 F. 2d 111 (5th Cir. 1962); Holt v. Commissioner, 303 F. 2d 687 (9th Cir. 1962), affg. 35 T.C. 588">35 T.C. 588 (1961); Harry M. Flower, 61 T.C. 140">61 T.C. 140 (1973), affd. 505 F. 2d 1302 (5th Cir. 1974); Joseph W. Brown, 40 T.C. 861">40 T.C. 861 (1963). On the other hand, the sale or exchange of an exclusive right to use or possess specific property will produce capital gain. United States v. Dresser Industries, Inc., 324 F. 2d 56 (5th Cir. 1963); Commissioner v. Ferrer, 304 F. 2d 125 (2d Cir. 1962), revg. in part 35 T.C. 617">35 T.C. 617 (1961); Commissioner v. McCue Bros. & Drummond, Inc., 210 F. 2d 752 (2d Cir. 1954), affg. 19 T.C. 667">19 T.C. 667 (1953), cert. denied 348 U.S. 829">348 U.S. 829 (1954); Commissioner v. Ray, 210 F. 2d 390 (5th Cir. 1954), affg. 18 T.C. 438">18 T.C. 438 (1952), cert. denied 348 U.S. 829">348 U.S. 829 (1954); Commissioner v. Golonsky, 200 F. 2d 72 (3d Cir. 1952), affg. 16 T.C. 1450">16 T.C. 1450 (1951), cert. denied 345 U.S. 939">345 U.S. 939 (1953).

The cases distinguishing a contract right associated with an interest in property from a mere right to earn income in the future have arisen from a variety of circumstances. Payments received by a lessee for the termination of a lease are treated as capital gain, Commissioner v. Golonsky, supra, and Commissioner v. McCue Bros. & Drummond, Inc., supra. Similarly a lessee's right to prevent his landlord from renting space to a competitor is a capital asset; Commissioner v. Ray, supra.Payments received for the relinquishment of an exclusive right to use another's patent have been treated as capital gain; United States v. Dresser Industries, Inc., supra.In Ferrer the taxpayer was granted, by the author of a novel, the sole and exclusive right to produce and present a play based upon the novel, as well as the power to prevent the author's disposition of the motion picture rights. Both of these rights carried the requisite property genes and were accorded capital asset status.

Capital asset status is denied, however, to a contract right, not associated with an interest in specific property, to earn income in the future. Payments received upon the cancellation of an employment or management contract, for example, are considered a substitute for income which would have been earned in the future and are accordingly taxed as ordinary income. In Eidson the taxpayers had a management contract with an insurance company whereby they had exclusive rights to solicit new business and to employ agents. Upon the sale of these rights, the Fifth Circuit determined that the proceeds represented the present cash value of what would otherwise have been ordinary income during the balance of the life of the contract and, therefore, taxed the proceeds as ordinary income. Accord Hyatt v. Commissioner, supra;United States v. Woolsey, supra.The Holt case, decided by the Ninth Circuit, involved a taxpayer who had a contract with Paramount Picture Corp., under which the taxpayer was to produce a number of motion pictures in return for a flat production fee for each picture plus a percentage of the gross receipts from each picture. After the production of nine motion pictures but prior to the commencement of the last two pictures to be produced under the contract, Paramount decided to terminate the contract. In consideration of the taxpayer's release of his rights to a percentage of the gross receipts due or to become due under the contract, Paramount agreed to pay a flat sum of $ 153,000. Under those circumstances the Ninth Circuit agreed with our holding that the taxpayer's right to participate in the gross receipts was compensation for services rendered or to be rendered under the contract and accordingly characterized the $ 153,000 as ordinary income.

Applying the principles set forth in the above cases to the facts of this case, we find that petitioner's rights under the operating agreement constituted property within the meaning of sections 1221 and 1231. We agree with petitioner that the operating agreement was in substance a lease rather than an employment contract. In arriving at this conclusion we have considered the following factors:

(1) Under the operating agreement petitioner was granted the sole and exclusive right to conduct the cardroom business on premises owned by Sekyra. We view the sole and exclusive right to conduct the business on the premises as tantamount to the use and possession of the premises. Use and possession are property rights normally transferred by a lease and not by an employment contract.

(2) Under the operating agreement petitioner was granted the sole and exclusive right to conduct the business. In a typical employer-employee relationship the employer has some element of control over the employee. Freese v. United States, 455 F. 2d 1146 (10th Cir. 1972), cert. denied 409 U.S. 879">409 U.S. 879 (1972). Here, Sekyra retained no element of control over petitioner or over the business.

(3) Petitioner was granted an unqualified option to renew the agreement for two additional 5-year terms. While renewal options are typically granted to lessees, they are not ordinarily granted to an employee under an employment contract.

(4) The operating agreement was to terminate upon petitioner's death but not upon Sekyra's death. Since the cardroom license would expire on Sekyra's death, petitioner's rights to occupy and use the premises after Sekyra's death indicate that Sekyra was leasing the premises and not merely hiring an employee to manage the cardroom.

(5) The operating agreement gave petitioner the right to retain all gross receipts after payment of a fixed monthly fee to Sekyra. ⁸ Petitioner was, therefore, not guaranteed any salary or remuneration. Sekyra, on the other hand, was guaranteed a fixed monthly payment. This arrangement meant that petitioner and not Sekyra would realize any losses incurred in the operation of the club. Petitioner was under no obligation to submit financial reports to Sekyra. Sekyra's only right under the agreement was to receive the specified monthly payment. These financial arrangements more nearly resemble those found in a lease than those found in an employment contract.

(6) Pursuant to article V of the operating agreement petitioner made a lump-sum payment of $ 7,500 to Sekyra in exchange for his rights under the agreement. ⁹ While such payments are typically made by a tenant pursuant to a lease agreement, they are not ordinarily made by an employee in exchange for rights under an employment contract.

We recognize that the written agreement between petitioner and Sekyra included language more indicative of an employment or management contract than of a lease. In fact, the agreement specifically states, "[Sekyra] does hereby hire [petitioner] * * *. [Petitioner] does hereby accept said management." We are of the opinion, however, that the parties intentionally used these words and avoided the terminology ordinarily found in a lease in an attempt to disguise the true nature of their agreement. Both were aware that a written agreement specifically indicating that Sekyra was leasing the cardroom to petitioner would result in the revocation of the license by county officials. Prior to entering into the operating agreement petitioner and Sekyra met with an attorney, Karl G. Kappel, for the purpose of relating to him their intentions regarding the Pass Club so that he could draft a document reflecting their agreement. Kappel's understanding was that the parties intended to effect a lease. In drafting the document, however, Kappel used words more indicative of an employment contract than of a lease in an attempt to "hang a horse sign on this cow." He was endeavoring, in other words, to draft an agreement creating a lease but which would appear to be merely an employment contract. He believed that the agreement drafted in this manner would comply with the intent of the parties without creating an obvious violation of county ordinances. We recognize the substance of this agreement rather than its form and characterize it as a lease. Petitioner's rights as lessee constitute property within the meaning of sections 1221 and 1231, Commissioner v. Golonsky, supra;Commissioner v. Ray, supra;Commissioner v. Ferrer, supra.

We are not persuaded that we should reach a contrary result merely because the settlement payments were computed as a percentage of the gross receipts realized from the operation of the club. Respondent believes that this fact indicates that the settlement payments were intended to compensate petitioner for what he would have earned had he continued to operate the club. Thus, respondent concludes that the settlement payments were a substitute for what would otherwise have been received at a future time as ordinary income, and that they should be taxed as ordinary income under the holding of Commissioner v. P. G. Lake, Inc., supra. We do not agree with respondent's conclusion. As we said in Harry F. Guggenheim, 46 T.C. 559">46 T.C. 559, 569 (1966):

We do not believe that the rationale of Lake is applicable to the present case. Simply because the property transferred will produce ordinary income, and such income is a major factor in determining the value of the property, does not necessarily mean that the amount received for the property is essentially a lump-sum substitute for ordinary income. See, United States v. Dresser Industries, Inc., 324 F. 2d 56 (C.A. 5, 1963); Commissioner v. Ferrer, 304 F. 2d 125 (C.A. 2, 1962), reversing in part 35 T.C. 617">35 T.C. 617 (1961); Metropolitan Building Co., 31 T.C. 971">31 T.C. 971 (1959), acq. 2 C.B. 6">1959-2 C.B. 6, reversed in part 282 F. 2d 592 (C.A. 9, 1960); Surrey, "Definitional Problems in Capital Gains Taxation," 69 Harv.L.Rev. 985 (1956).

We pointed out in Guggenheim that in ascertaining whether a capital asset has been transferred (as opposed to an income interest) it is important to determine whether the risks associated with the holding of the asset have been transferred. Under the operating agreement petitioner retained all the profits and was subject to the risk of all losses incurred in the operation of the club. Sekyra, on the other hand, received payment regardless of whether there were profits. Under the settlement agreement, however, petitioner received a percentage of the gross receipts regardless of whether the club generated a profit and Sekyra became subject to the risk of incurring operating losses. We believe there was a transfer of the underlying investment risk and not merely a transfer of an income interest.

Having concluded that petitioner's rights under the operating agreement were essentially those of a lessee and that these rights constituted property for purposes of section 1231, we must decide whether the transfer of these rights otherwise qualifies for capital gain treatment under section 1231. There is no question but that the holding period requirement has been met and that the lease was property used in petitioner's trade or business. Furthermore, the lease was subject to the allowance for depreciation. Beginning with his 1962 return, petitioner amortized the $ 7,500 cost of acquiring the leasehold consistent with section 1.162-11(a), Income Tax Regs. Petitioner also amortized the cost of purchased equipment and improvements made to the leased property pursuant to section 1.162-11(b), Income Tax Regs. Respondent audited petitioner's 1963 return and the amortization deductions were not disallowed. Items which are amortizable are of a character subject to depreciation as required under section 1231(b). Estate of John F. Shea, 57 T.C. 15">57 T.C. 15 (1971).

Finally, we must decide whether the termination of petitioner's rights was a sale or exchange. While there are cases holding that the cancellation or termination of contract rights is not a sale or exchange, Holt v. Commissioner, supra;Leh v. Commissioner, 260 F. 2d 489 (9th Cir. 1958), affg. 27 T.C. 892">27 T.C. 892 (1957); Commissioner v. Starr Bros., 204 F. 2d 673 (2d Cir. 1953), revg. 18 T.C. 149">18 T.C. 149 (1952); we are not bound by these decisions in this instance. We have found that in substance the operating agreement granted petitioner a lease and that the settlement agreement effected a cancellation of that lease. Section 1241 provides, "Amounts received by a lessee for the cancellation of a lease * * * shall be considered as amounts received in exchange for such lease." The payments received by petitioner pursuant to the settlement agreement fall within section 1241 and are, therefore, deemed to be in exchange for his rights under the operating agreement. Having met all the requirements under section 1231, petitioner is entitled to treat the gain realized upon the termination of the operating agreement as capital gain.

Respondent argues that even if we find a sale or exchange of section 1231 property, a portion of the payments received in 1966 pursuant to the settlement agreement constitutes ordinary income. Respondent points to the fact that petitioner claimed a loss deduction in 1965 equal to his remaining basis in the leasehold and various improvements, which loss was recovered by way of the settlement payments received in 1966. Respondent maintains that since the loss deduction reduced petitioner's taxable ordinary income for 1965 that portion of the settlement payments received in 1966, equal to the prior deduction, constituted a recovery of the loss and should be treated as ordinary income under First National Bank of Lawrence County, 147">16 T.C. 147 (1951). Our decision in that case was based upon the accounting principle, sometimes referred to as the tax benefit rule, under which amounts deducted from income in one year must be included in income if recovered in a later year. That principle is not applicable, however, where the initial deduction was improper. Adolph B. Canelo III, 53 T.C. 217 (1969), affd. 447 F. 2d 484 (9th Cir. 1971); Streckfus Steamers, Inc., 19 T.C. 1">19 T.C. 1 (1952). In our opinion the loss claimed by petitioner in his 1965 return was improperly allowed by respondent. Petitioner's return indicated that the deduction was taken pursuant to section 1.167(a)-8(a)(4), Income Tax Regs.¹⁰ That regulation provides, in part:

(4) Where an asset is retired by actual physical abandonment (as, for example, in the case of a building condemned as unfit for further occupancy or other use), loss will be recognized measured by the amount of the adjusted basis of the asset abandoned at the time of such abandonment. In order to qualify for the recognition of loss from physical abandonment, the intent of the taxpayer must be irrevocably to discard the asset so that it will neither be used again by him nor retrieved by him for sale, exchange, or other disposition.

During 1965, however, petitioner never intended to abandon the leasehold, at least not in the sense of irrevocably discarding it so that it could not become the subject of a sale, exchange, or other disposition by him. In fact, at the time petitioner vacated the premises, in November 1965, he was actively negotiating with Sekyra for a cash payment in exchange for his rights as a lessee. These negotiations continued until the settlement agreement was reached in January 1966. Under these circumstances petitioner was not entitled to a loss deduction in 1965. Since the deduction was improper, respondent's reliance upon the so-called tax benefit rule for purposes of characterizing a subsequent recovery of the loss as ordinary income is inappropriate.

In this regard, we note that petitioner reported the full amount of the payments received in 1966 (less selling expenses) as gain. Respondent has invoked the tax benefit rule, therefore, not to increase the amount of petitioner's income in 1966, but merely to characterize a portion of it as ordinary income rather than capital gain. In our view there is a more direct way in which a portion of the payments received in 1966 can be characterized as ordinary income.

Section 1245¹¹ provides that the gain realized upon a disposition of depreciable personal property shall be treated as ordinary income to the extent of the depreciation previously allowed in respect of the property. Petitioner's rights under the operating agreement, which we have characterized as a lease, included: (1) Use and possession of the land and building; (2) use and possession of certain personal property located on the premises; and (3) use of the cardroom license. The latter two rights constitute section 1245 property as defined in section 1245(a)(3) and section 1.1245-3, ¹² Income Tax Regs.

In the case of a lease of both section 1245 property and non-section 1245 property, the regulations require a determination of their respective market values at the beginning of the lease in order to determine what percentage of the leasehold constitutes section 1245 property. As no evidence has been presented in this regard, we leave that determination for the Rule 155 computation. In order to determine how much of the amount realized, upon disposition of the lease, is in respect of section 1245 property, the regulations require that the sales proceeds be allocated between section 1245 property and non-section 1245 property in proportion to their respective fair market values. This allocation must also be left for the Rule 155 computation.

Petitioner's right to the use and possession of the land and building constituted section 1250 property. Sec. 1250(c) and sec. 1.1250-1(e)(3), Income Tax Regs. Under section 1250, only "additional depreciation" is recaptured. Section 1250(b)(1) defines "additional depreciation" thusly:

(b) Additional Depreciation Defined. -- For purposes of this section --

(1) In general. -- The term "additional depreciation" means, in the case of any property, the depreciation adjustments in respect of such property; except that, in the case of property held more than one year, it means such adjustments only to the extent that they exceed the amount of the depreciation adjustments which would have resulted if such adjustments had been determined for each taxable year under the straight line method of adjustment. For purposes of the preceding sentence, if a useful life (or salvage value) was used in determining the amount allowed as a deduction for any taxable year, such life (or value) shall be used in determining the depreciation adjustments which would have resulted for such year under the straight line method.

Petitioner held the property for more than 1 year and used the straight line method of depreciation. Consequently, there is no "additional depreciation" to be recaptured.2. Self-Employment Income

Respondent determined that the payments received by petitioner under the settlement agreement constituted net earnings from self-employment under section 1402 and accordingly increased petitioner's self-employment tax under section 1401 for 1966, 1967, and 1968. This determination was based upon respondent's conclusion that the settlement payments were taxable as ordinary income. As we have determined that the settlement payments are taxable as capital gain, they do not constitute net earnings from self-employment. Sec. 1402(a)(3)(A).

3. Promissory Note

The settlement agreement required Sekyra to pay petitioner the specified amount of $ 14,000 in addition to the percentage payments. In 1966 Sekyra paid petitioner $ 4,000 in cash and delivered to petitioner a negotiable promissory note in the principal amount of $ 10,000. She paid $ 7,000 of the principal amount in 1966 and the $ 3,000 balance in 1967.

Respondent determined that the principal amount of $ 10,000 was includable in petitioner's income in 1966. Petitioner contends that only the $ 7,000 paid on the note in 1966 is includable in that year, and that the remaining $ 3,000 is income in 1967.

It is well established that a taxpayer must include in income, for the year of receipt, the fair market value of a negotiable promissory note of a responsible and solvent maker. Scharf's Estate v. Commissioner, 316 F. 2d 625 (7th Cir. 1963), affg. 38 T.C. 15">38 T.C. 15 (1962); Harry Leland Barnsley, 31 T.C. 1260">31 T.C. 1260 (1959). Petitioner has introduced no evidence to contradict respondent's determination that the fair market value of his note was equal to its face amount. We must, therefore, agree with respondent's determination that the full amount of the note is income in 1966. Aaron W. Wolfson, 1 B.T.A. 538">1 B.T.A. 538 (1925).

4. Commission Income

Respondent determined that petitioner realized Commission income in 1966 in the amount of $ 2,042, which was not reported on his return. Respondent's determination is presumptively correct. Rule 142(a), Tax Court Rules of Practice and Procedure. As petitioner has introduced no evidence to refute respondent's determination, we uphold that determination.

5. Imputed Interest

The parties have agreed that if we should find the settlement payments were received in exchange for section 1231 property, a computation must be made under section 483 to determine the amount which is deemed interest income. This is a matter for the Rule 155 computation.

Decision will be entered under Rule 155.

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Footnotes

• 1. After trial respondent was permitted to file an amended answer to conform the pleadings to the proof and to assert in the alternative an increased deficiency for the year 1967. The increased deficiency for 1967 is asserted in the event that the principal amount of a promissory note received in 1966 is not income in 1966.↩

• 2. The agreement refers to Sekyra as Coons. In order to avoid confusion we have substituted her present name, Sekyra, wherever she is referred to in the agreement.↩

• 3. The agreement refers to petitioner as "King" -- evidently a nickname. In order to avoid confusion we have substituted "petitioner" wherever he is referred to in the agreement.↩

• 4. We have substituted "Sekyra" where she is referred to by her former name.↩

• 5. Art. 4, sec. 6143, Ventura County Ordinances.↩

• 6. We have again substituted "Sekyra" and "petitioner" for "Coons" and "King," respectively.↩

• 7. See Eustice, "Contract Rights, Capital Gain, and Assignment of Income -- the Ferrer Case," 20 Tax L. Rev. 1">20 Tax L. Rev. 1↩ (1964).

• 8. Although the written operating agreement specifically fixes the monthly payments at $ 2,000, respondent argues that the parties, in fact, agreed that the payments would increase as the profits increased. In advancing this argument, respondent relies on testimony given by Sekyra to the effect that petitioner was obligated under an oral agreement to increase the monthly payments as the profits increased. Sekyra's testimony, however, was confused and not very specific. She could not recall when the oral agreement occurred or even whether it occurred before or after the written agreement was signed. Furthermore, all of Sekyra's testimony left the impression that she believed a decision favorable to petitioner in this case would somehow have an adverse effect on her right to retain the cardroom license and continue to operate the club. Our finding that petitioner was not obligated to increase the monthly payments is based upon: (1) The written agreement; (2) petitioner's denial that any such oral agreement occurred; and (3) the absence of any satisfactory explanation as to why an agreement to share the profits would not have been reduced to writing. In light of the club's financial success and because the club's continued operation as a cardroom depended upon Sekyra's willingness to renew the license each year, we do not find it surprising that petitioner periodically agreed to increase the monthly payments.

• 9. Although the $ 7,500 payment was stipulated, respondent attempted to establish at trial that this transfer of funds constituted a loan. The only evidence to that effect is Sekyra's testimony that the payment was a loan. But she could not recall having signed a note nor could she recall the terms of repayment. No note was introduced as evidence nor is there any indication in the record that payments have been made on the purported loan. No mention was made in the settlement agreement of payments due on a loan. Again, we found Sekyra's testimony confused. We further believe that testimony was tainted by a belief on her part that the cardroom license might yet be revoked by county officials based upon a finding by this Court that she had leased the cardroom to petitioner.

• 10. Sec. 1.165-2(c), Income Tax Regs., provides:

  (c) Cross references. For the allowance under section 165(a) of losses arising from the permanent withdrawal of depreciable property from use in the trade or business or in the production of income, see § 1.167(a)-8. [T.D. 6445↩, 1-15-60.]

• 11. SEC. 1245. GAIN FROM DISPOSITIONS OF CERTAIN DEPRECIABLE PROPERTY.

  (a) General Rule. --

  (1) Ordinary income. -- Except as otherwise provided in this section, if section 1245 property is disposed of during a taxable year beginning after December 31, 1962, the amount by which the lower of --

  (A) the recomputed basis of the property, or

  (B) (i) in the case of a sale, exchange, or involuntary conversion, the amount realized, or

  (ii) in the case of any other disposition, the fair market value of such property,

  exceeds the adjusted basis of such property shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231. Such gain shall be recognized notwithstanding any other provision of this subtitle.

  (2) Recomputed basis. -- For purposes of this section the term "recomputed basis" means --

  (A) with respect to any property referred to in paragraph (3)(A) or (B), its adjusted basis recomputed by adding thereto all adjustments, attributable to periods after December 31, 1961,

  * * *

  reflected in such adjusted basis on account of deductions (whether in respect of the same or other property) allowed or allowable to the taxpayer or to any other person for depreciation, or for amortization under section 168, 169, 184, 185, 187, or 188. For purposes of the preceding sentence, if the taxpayer can establish by adequate records or other sufficient evidence that the amount allowed for depreciation, or for amortization under section 168, 169, 184, 185, 187, or 188, for any period was less than the amount allowable, the amount added for such period shall be the amount allowed.

  (3) Section 1245 property. -- For purposes of this section, the term "section 1245 property" means any property which is or has been property of a character subject to the allowance for depreciation provided in section 167 (or subject to the allowance of amortization provided in section 185) and is either --

  (A) personal property, ↩

• 12. Sec. 1.1245-3 Definition of section 1245 property.

  (a) In general. (1) The term "section 1245 property" means any property (other than livestock excluded by the effective date limitation in subparagraph (4) of this paragraph) which is or has been property of a character subject to the allowance for depreciation provided in section 167 and which is either --

  (i) Personal property (within the meaning of paragraph (b) of this section),

  * * *

  (2) If property is section 1245 property under a subdivision of subparagraph (1) of this paragraph, a leasehold of such property is also section 1245 property under such subdivision. Thus, for example, if A owns personal property which is section 1245 property under subparagraph (1)(i) of this paragraph, and if A leases the personal property to B, B's leasehold is also section 1245 property under such provision. For a further example, if C owns and leases to D for a single lump-sum payment of $ 100,000 property consisting of land and a fully equipped factory building thereon, and if 40 percent of the fair market value of such property is properly allocable to section 1245 property, then 40 percent of D's leasehold is also section 1245 property. A leasehold of land is not section 1245 property.

  * * *

  (b) Personal property defined. The term "personal property" means --

  (1) Tangible personal property (as defined in paragraph (c) of § 1.48-1, relating to the definition of "section 38 property" for purposes of the investment credit), and

  (2) Intangible personal property.↩