Commissioner v. P.G. Lake, Inc.
356 U.S. 260 (1958)
Lake was a company that
produced oil and gas. They owned some oil and gas leases, which entitled
them to a percentage of the profits from selling oil and gas from certain
Those profits were taxable
as ordinary income.
Lake owed their President
$600k. Instead of paying him in cash, they gave him their interest in an oil
lease, so he'd get the profits from it instead of them.
When they filed their taxes,
Lake claimed that they had sold a capital asset and therefore reported the $600k as a capital
gain. The IRS assessed a deficiency.
Lake argued that there was
an actual asset sold (the lease), and they were not in the business of
buying and selling leases, so it was a capital gain.
The IRS argued that the oil
leases were nothing more than a contractual agreement to get a stream of
income. Therefore by using the leases to pay off a debt, all Lake was
doing was collecting the $600k of income they would have normally gotten
over the next few years all at once.
The Tax Court found for the
IRS. Lake appealed.
The Appellate Court reversed.
The IRS appealed.
The US Supreme Court reversed
and found for the IRS.
The US Supreme Court found
that the lease was a transparent device. Collecting income now instead of later is just an acceleration
of ordinary income and not
eligible to be a capital gain.
Basically, the Court said
that the lease wasn't a capital asset
(like an office building or a piece of machinery) would be. It was just
a license to get some money (which would be ordinary income) later. When Lake sold it they weren't
selling a capital asset,
they were giving up the right to get money later in order to get money
now. That's just ordinary income received on a different timetable.