Rev. Rul. 58-301

Advice has been requested whether an amount received by an employee as consideration for the cancellation of an employment contract constitutes ordinary income or capital gain, and, in either event, the taxable year of its inclusion in gross income.

In the instant case, the taxpayer was employed under a written contract providing for five years of employment. During the second year of employment, the taxpayer and his employer agreed to cancel the remaining period of the contract. In consideration of the taxpayer's relinquishment of his contract rights, the employer paid him 40 x dollars during the taxable year.

In order for a transaction to result in a capital gain or loss , it must meet the requirements of sections 1221 and 1222 of the Internal Revenue Code of 1954, which set forth the meaning of `capital asset' in terms of property and classifies capital gains and losses arising from the sale or exchange of them. First of all it must fall within the meaning of property qualifying as a capital asset under section 1221 and then there has to be a sale or exchange of the property under section 1222. Under the facts of the instant case, the taxpayer fails to meet the requirements under both sections.

In Thurlow E. McFall et al. v. Commissioner , 34 B.T.A. 108, the United States Board of Tax Appeals, in determining that the sale and assignment of an employment contract to a third person did not result in a capital gain to the petitioners, stated, in part:

* * * there was a right of petitioners to continue to perform service and then to be paid-to persist in their contractual relation for its agreed term. While this right is property in the constitutional sense in that it could not be arbitrarily legislated away, it is not capital. * * *. Obviously it is not the sort of property which is susceptible of ownership for a length of time as is a share of stock, a bond, or a thing.

A similar conclusion was reached in George K. Gann v. Commissioner , 41 B.T.A. 388, where the Board held that the amount received by an employee from his employer in consideration for the cancellation of a contract of employment which had several years to run was ordinary income and not a capital gain. The decision was predicated on the fact that the qualifications and skill of the employee formed the material ingredient of the contract and such a contract could not be sold. See also Charles J. Williams v. Commissioner , 5 T.C. 639; General Artists Corporation v. Commissioner , 205 Fed.(2d) 360, certiorari denied 346 U.S. 866; and W. Morgan Shuster v. Helvering , 121 Fed.(2d) 643.

Under certain circumstances, income received in one year may be taxed as if received ratably over the years in which it was earned. See sections 1301-1305, inclusive, of the Code, relating to the taxation of income attributable to several taxable years. The provisions of these sections, however, are by their terms inapplicable to the instant case.

Accordingly, it is held that a lump sum payment received by an employee as consideration for the cancellation of his employment contract constitutes gross income to the recipient in the taxable year of receipt. However, such amount is not subject to the Federal employment and income tax withholding provisions of section 3121 of the Federal Insurance Contributions Act and section 3402 of the Code, (Chapters 21 and 24, respectively, Subtitle C, Internal Revenue Code of 1954). See Rev. Rul. 55-520, C.B. 1955-2, 393.