[Code of Federal Regulations]
[Title 26, Volume 11]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.1241-1]

[Page 332-334]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.1241-1  Cancellation of lease or distributor's agreement.

    (a) In general. Section 1241 provides that proceeds received by 
lessees or distributors from the cancellation of leases or of certain 
distributorship agreements are considered as amounts received in 
exchange therefor. Section 1241 applies to leases of both real and 
personal property. Distributorship agreements to which section 1241 
applies are described in paragraph (c) of this section. Section 1241 has 
no application in determining whether or not a cancellation not 
qualifying under that section is a sale or exchange. Further, section 
1241 has no application in determining whether or not a lease or a 
distributorship agreement is a capital asset, even though its 
cancellation qualifies as an exchange under section 1241.

[[Page 333]]

    (b) Definition of cancellation. The term cancellation of a lease or 
a distributor's agreement, as used in section 1241, means a termination 
of all the contractual rights of a lessee or distributor with respect to 
particular premises or a particular distributorship, other than by the 
expiration of the lease or agreement in accordance with its terms. A 
payment made in good faith for a partial cancellation of a lease or a 
distributorship agreement is recognized as an amount received for 
cancellation under section 1241 if the cancellation relates to a 
severable economic unit, such as a portion of the premises covered by a 
lease, a reduction in the unexpired term of a lease or distributorship 
agreement, or a distributorship in one of several areas or of one of 
several products. Payments made for other modifications of leases or 
distributorship agreements, however, are not recognized as amounts 
received for cancellation under section 1241.
    (c) Amounts received upon cancellation of a distributorship 
agreement. Section 1241 applies to distributorship agreements only if 
they are for marketing or marketing and servicing of goods. It does not 
apply to agreements for selling intangible property or for rendering 
personal services as, for example, agreements establishing insurance 
agencies or agencies for the brokerage of securities. Further, it 
applies to a distributorship agreement only if the distributor has made 
a substantial investment of capital in the distributorship. The 
substantial capital investment must be reflected in physical assets such 
as inventories of tangible goods, equipment, machinery, storage 
facilities, or similar property. An investment is not considered 
substantial for purposes of section 1241 unless it consists of a 
significant fraction or more of the facilities for storing, 
transporting, processing, or otherwise dealing with the goods 
distributed, or consists of a substantial inventory of such goods. The 
investment required in the maintenance of an office merely for clerical 
operations is not considered substantial for purposes of this section. 
Furthermore, section 1241 shall not apply unless a substantial amount of 
the capital or assets needed for carrying on the operations of a 
distributorship are acquired by the distributor and actually used in 
carrying on the distributorship at some time before the cancellation of 
the distributorship agreement. It is immaterial for the purposes of 
section 1241 whether the distributor acquired the assets used in 
performing the functions of the distributorship before or after 
beginning his operations under the distributorship agreement. It is also 
immaterial whether the distributor is a retailer, wholesaler, jobber, or 
other type of distributor. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Taxpayer is a distributor of various food products. He 
leases a warehouse including cold storage facilities and owns a number 
of motor trucks. In 1955 he obtains the exclusive rights to market 
certain frozen food products in his State. The marketing is accomplished 
by using the warehouse and trucks acquired before he entered into the 
agreement and entails no additional capital. Payments received upon the 
cancellation of the agreement are treated under section 1241 as though 
received upon the sale or exchange of the agreement.
    Example 2. Assume that the taxpayer in example (1) entered into an 
exclusive distributorship agreement with the producer under which the 
taxpayer merely solicits orders through his staff of salesmen, the goods 
being shipped direct to the purchasers. Payments received upon the 
cancellation of the agreement would not be treated under section 1241 as 
though received upon the sale or exchange of the agreement.
    Example 3. Taxpayer is an exclusive distributor for M city of 
certain frozen food products which he distributes to frozen-food freezer 
and locker customers. The terms of his distributorship do not make it 
necessary for him to have any substantial investment in inventory. 
Taxpayer rents a loading platform for a nominal amount, but has no 
warehouse space. Orders for goods from customers are consolidated by the 
taxpayer and forwarded to the producer from time to time. Upon receipt 
of these goods, taxpayer allocates them to the individual orders of 
customers and delivers them immediately by truck. Although it would 
require a fleet of fifteen or twenty trucks to carry out this operation, 
the distributor uses only one truck of his own and hires cartage 
companies to deliver the bulk of the merchandise to the customers. 
Payments received upon the cancellation of the distributorship agreement 
in such a case would not be considered received upon the sale or 
exchange of the agreement under section 1241 since the taxpayer does not 
have facilities for the physical handling

[[Page 334]]

of more than a small fraction of the goods involved in carrying on the 
distributorship and, therefore, does not have a substantial capital 
investment in the distributorship. On the other hand, if the taxpayer 
had acquired and used a substantial number of the trucks necessary for 
the deliveries to his customers, payments received upon the cancellation 
of the agreement would be considered received in exchange therefor under 
section 1241.

[T.D. 6500, 25 FR 12021, Nov. 26, 1960]