The following article is reprinted from The M&A Tax Report, Vol. 12, No. 5, December 2003, Panel Publishers, New York, NY.

BUSINESS LITIGATION RECOVERIES — THE CAPITAL VS. ORDINARY DEBATE CONTINUES TO SMOLDER

By Robert W. Wood

The distinction between ordinary income and capital gain is fundamental to our income tax system. Capital gain tax rate preferences in both magnitude and extent come and go. But, it is virtually always better to receive a capital gain rather than ordinary income. C corporations are currently in the unenviable position of not having a tax rate preference. Nevertheless, even C corporations can have a marked incentive to receive capital rather than ordinary treatment. The most obvious advantage to capital treatment is that there often will be a basis in the affected asset(s) against which some of the recovery can be sheltered.

The tax treatment of litigation payments and recoveries has become increasingly important in recent years. Even so, businesses are increasingly sensitive today to the characterization questions implicit in paying or receiving a settlement or judgment in a lawsuit. This is certainly true in considering the tax treatment of business litigation recoveries.

Overriding Principles

It is axiomatic that litigation recoveries are to be taxed according to the nature of the underlying claims. Just as taxpayers have obvious incentives to characterize amounts received in business litigation as attributable to capital assets (for example, harm to goodwill), the government has an equally clear incentive: to view all amounts received as ordinary income. The IRS will invariably express a strong preference for ordinary income (lost profits) treatment.

It is easy enough to say that one determines a plaintiff's tax treatment by referring to the genesis and gravamen of the underlying claims. See Arrowsmith v. Commissioner, 344 U.S. 6 (1952). However, lawsuits often involve multiple claims and complex facts. Sometimes, determining the "origin" of a claim seems a task fit for Dr. Leaky. Sometimes, too, it can be confusing whether the origin of a claim or the potential consequences of a claim are most relevant. Thus, in the seminal Gilmore case, the U.S. Supreme Court had to decide whether the tax consequences of a lawsuit turned on the origin of the lawsuit (a personal divorce), or on the potential consequences of that suit (Mr. Gilmore's potential loss of his car dealership businesses). 372 U.S. 39 (1963). The Supreme Court decided it was the former, making the substantial attorneys' fees paid by Gilmore (which he asserted were deductible because paid to protect his business assets) nondeductible.

The classic example of a payment held taxable as capital is a payment for damage to goodwill. Durkee v. Commissioner, 162 F.2d (6th Cir. 1947). Where there is an ascertainable value to the capital assets damaged or destroyed and a suit is brought to recover for their value as well as for resulting lost profits, it may be a simple matter to determine what portion of the recovery constitutes damages for lost profits, and what part of the recovery constitutes damages for injury to capital assets. See Arcadia Refining Co. v. Commissioner, 118 F.2d 1010 (5th Cir. 1941)

Excess of Basis

Where a recovery compensates a plaintiff for injuries to a capital asset, the recovery constitutes a tax free return of capital to the extent of the taxpayer's basis in the injured asset. Raytheon Production Corp., supra, 144 F.2d 110, 113 (1st Cir. 1944). The rationale for this principle is that no economic gain results from a basis recovery. Rev. Rul. 81-277, 1981-2 C.B. 14 (1981). Only amounts received in excess of the taxpayer's basis constitute income. Id. An award may therefore produce capital gain (or reduce capital loss) depending on the taxpayer's basis in the asset.

As a general rule, where there is injury to an identifiable capital asset, recoveries in excess of basis are treated as capital gains. For example, in Daugherty v. Commissioner, the Tax Court stated: "If the claim is for damage to a capital asset, the amount received in settlement is treated as a return of capital, taxable at capital gain rates if the recovery exceeds the asset's basis." 78 T.C. 623, 638-39 (1982).

In Big Four Industries, Inc. v. Commissioner, the court held that a portion of an award in a patent infringement case was for damage to "capital structure and goodwill" (which the taxpayer retained), and that this payment constituted solely capital gain because the taxpayer had no tax basis in its goodwill. 40 T.C. 1055 (1963). The Commissioner argued that the portion of the award was for lost profits and therefore constituted ordinary income. The taxpayer argued that the award was for damage to goodwill and therefore was not taxable at all. The court disagreed with both parties and held that the entire amount was capital gain. See also Freeman v. Commissioner, 33 T.C. 323 (1959).

The Big Four decision is a good example of a court sifting through the facts and the pleadings of a case to find the nature of the dispute. Disputes are often multi-faceted, and the court in Big Four found that some elements were explicitly ordinary in nature, while others were capital in nature. The Tax Court found that some of the award was to reimburse the taxpayer for attorneys' fees and various other costs. Finding these to be ordinary in nature (and noting that in any case the taxpayer was being reimbursed for costs it had already deducted), the court went on to examine other portions of the award which were expressly related to damages to the capital structure and goodwill of the taxpayer. Interestingly, the court in Big Four noted that in the underlying litigation, the taxpayer had not specifically requested damages for harm to goodwill.

Yet, the Tax Court was satisfied that the court in the underlying proceeding had in fact granted that relief, so that a portion of the recovery was fairly attributable to capital. Unfortunately for the taxpayer, even though the Tax Court concluded that part of the award represented damages to the taxpayer's capital structure and goodwill, that was not the end of the matter. If such amounts did not exceed the basis of the capital interest or goodwill destroyed, it would be nontaxable. If it exceeded the amount of that basis, it would be taxable as capital gain. The record in the underlying litigation indicated that there was no damage to any physical assets, and since the taxpayer had no cost basis for its goodwill, all of this portion of the lawsuit recovery was held to be taxable as a capital gain.

Carrying the Burden (Oh, It's Heavy)

In Raytheon the taxpayer received $410,000 from RCA in settlement of an antitrust suit charging injury to its business. The settlement agreement did not allocate between payment for patent and license rights and an amount for settlement of the suit. Later, Raytheon's officers testified that $60,000 was the maximum worth of the patents, supporting the $60,000 allocated to the payment for patent and license rights on Raytheon's return. The other $350,000 was held to be taxable as ordinary income because Raytheon did not demonstrate the receipt of capital replacement, nor had it shown any cost or other basis for the goodwill in the business which was allegedly destroyed.

The court noted that it found nothing in the suit to show that it was for lost profits, but with no proof of the basis of goodwill, had to find the entire recovery taxable. The Raytheon court noted that it found nothing in the suit to show that it was for lost profits. However, with no proof of the basis of goodwill, the Tax Court felt it had to find the entire recovery taxable. Thus, the argument that a recovery is taxable really has two prongs: first, that the recovery is capital in nature; and second, that there is basis in the capital asset.

One of the primary benefits of capital treatment, of course, is the ability to recover against the basis of affected asset(s). The amount of the taxpayer's basis in an asset determines the timing of the recovery. If there is no disposition, the recovery reduces basis and may be taken into account through reduced depreciation or amortization in the future. Alternatively, it would be taxable immediately, to the extent it exceeds basis. If there is a disposition at the time of the recovery, the recovery would be taken into account then, and may not result in gain if there is sufficient basis. It may even reduce a taxable loss.

Proving Capital Asset Status and Basis

The cases are legion in which the taxpayer is unable to demonstrate a return of capital, or for that matter, any injury to a capital asset. See Elliott v. Commissioner, T.C. Memo. 1987-333. A review of the case law may leave the advisor nonplussed about the chances of capital treatment. In Biocraft Laboratories, Inc. v. Commissioner, payments received by a manufacturer from a customer in consideration for the customer's release from a product requirements contract were held to compensate the plaintiff manufacturer for anticipated lost profits. T.C. Memo. 1980-268 (1980). Therefore, the payments were held to be ordinary income. The taxpayer had argued that the payments were in consideration for an option purchase, and therefore could be held in abeyance until the option was either exercised or lapsed.

The manner in which a taxpayer may be successful in demonstrating harm to capital assets, and therefore prove that at least some amount should be taxable as capital gain rather than ordinary income is well-illustrated by Berbiglia v. Commissioner,10 T.C.M. (CCH) 413 (1951). In that case, the taxpayer sued for a breach of contract occurring upon the withdrawal of a bottling franchise. The amount received in settlement of the suit was less than the loss claimed on the investment in physical assets or advertising. Accordingly, the taxpayer was successful in showing that the amount received did not represent a payment for loss of future profits, but was strictly a recovery of capital (and not even a complete one at that). The recovery was therefore excludable from gross income.

With some capital assets, it may be very difficult to show that a recovery should not be treated as ordinary income. Thus, although a patent is clearly a capital asset (or Section 1231 asset) with respect to many businesses, damages may relate solely to a right or expectancy of exploiting the patent, an act that would produce ordinary income. For example, in Kucera v. Commissioner, the taxpayer received an amount in settlement of a suit in which he sought damages from the purchaser of the patent for failure to produce the patented item. 10 T.C.M. (CCH) 303 (1951). The settlement was held to be in lieu of the profits he would have received from the manufacturer, rather than a payment for loss of goodwill.

The importance of basis and being able to prove it is well-illustrated by H. Doud v. Commissioner, T.C. Memo. 1982-158 (1982). In that case, a taxpayer received an amount in settlement from a bank. The suit related to the disappearance of the plaintiff's stamp collection which the bank had held as collateral for a loan. The taxpayer showed that the settlement amount equaled his basis in the stamps. Therefore his recovery was held nontaxable.

Similarly, in Charlie Sturgill Motor Co. v. Commissioner, amounts received by the taxpayer based upon an error by the state in condemnation proceedings were held includable in income only to the extent that the award exceeded the adjusted basis of the property. T.C. Memo. 1973-281. Conversely, where the taxpayer is unable to prove that the entire recovery represents a recovery of capital, any overage will be taxable income. Morse v. Commissioner, 371 F.2d 474 (1967).

Occasionally, one must look beyond traditional business litigation for authority, and beyond case law altogether. A series of Private Letter Rulings have ruled that amounts recovered by a condominium or homeowners association for construction defects do not constitute income to the association or to its member-homeowners. Rather, such amounts have been determined to represent a return of capital. See Ltr Ruls 9343025, 9335019, 9131023 and 9041072.

In Ila I. Gail v. United States, the Tenth Circuit ruled that a judgment a woman received to compensate her after natural gas had been removed from her property without her knowledge had to be allocated. 58 F.3d 580 (10th Cir. 1995). The court determined that the recovery had to be allocated between royalties (which were ordinary income) and diminution in value to the property (which were characterized as capital gains). Mrs. Gail had failed to declare any portion of the recovery as income, and the IRS disagreed. Mrs. Gail paid the deficiency assessed by the IRS, and then sued for a refund in federal district court.

The district court ruled that the IRS had been correct, and that the entire recovery was ordinary income. The appellate court, however, found that only part of the recovery was taxable as ordinary income. While the court found that a portion of the recovery represented royalties (ordinary income), it found that the balance was compensation for diminution to the value of her property that was taxable as a capital gain.

In Brenda J. Wachner v. Commissioner, the Tax Court held that settlement proceeds constituted ordinary income. T.C. Memo. 1995-88 (1995). The taxpayer had argued that her dispute with her former employer resulted in a capital gain to her because she exchanged equity interests in her employer for cash. The case involved equity participation in a transaction that she alleged she was supposed to have received. Ultimately, the Tax Court found that the taxpayer had failed to meet her burden of proof on the capital asset and exchange points. Consequently, the court held that the entire recovery represented ordinary income.

Arguments abound about the nature of the claims asserted, and why despite appearances, those claims were capital rather than ordinary in nature. Some claims may invite difficult discovery, may be based on an applicable statute of limitations, etc. For example, in Oleck v. Commissioner, the court rejected the taxpayer's claim that part of the damages he recovered in an antitrust action were for damages to his health, reputation or goodwill. T.C. Memo. 1961-306 (1961). The taxpayer contended that he had brought an antitrust action in order to avoid the statute of limitations which would have run on an action based on the destruction of capital and/or goodwill, and for the damage to the taxpayer's character, reputation and health.

It is difficult to draw conclusions from the morass of case law. Nevertheless, it cannot be overemphasized that where a taxpayer is unable to establish the cost or basis of any capital asset (such as goodwill) which was allegedly lost or damaged by the defendant's actions, the entire recovery is likely to be taxable as ordinary income. See Chalmers Cullins v. Commissioner, 24 T.C. 322 (1955). Of course, as a technical matter, there should be no reason why a recovery which is indisputably capital in nature should not simply produce capital gain (albeit with no demonstrated basis). Unfortunately, there has been a tendency in the case law to treat a recovery as ordinary income where the taxpayer cannot establish cost or basis in an asset. Perhaps this reflects a blending together of the character of the recovery (as ordinary or capital) and the basis question.

That's All Folks

In business litigation as in all other litigation contexts, taxpayers should endeavor whenever possible to include express allocation language (including tax reporting, if any) in settlement agreements. Although some may dismiss such devices as self-serving window dressing, express tax treatment, whether the parties are truly adverse on these issues or not, is always better than nothing. Where the parties are adverse and they bargain over such language in the settlement agreement, the degree of helpfulness of the document in later dealing with the Service should not be undersold. See McKay v. Commissioner, 102 T.C. 465 (1994), vacated, No. 94-41189 (5th Cir. 1996).

The incentives for capital treatment in a business context are obvious. Even though the likelihood of a return to capital gain rates for corporations may seem highly unlikely in the current legislative milieu, an increasing number of businesses are not operated as corporations (or at least are operated as S corporations, making the capital gain rates of advantage to the shareholders). Even for C corporations, capital recoveries against basis are obviously attractive.

Ultimately, however, the inquiry must begin with the origin of the claim. Then, if the origin of the claim is harm to capital, the taxpayer must show the amount of its basis in the capital asset damaged or destroyed. If the taxpayer has no basis in that caital asset, or if their recovery is in excess of that basis, it should be taxed as capital gain. However, taxpayers must be mindful of the Service's strong incentive to treat all recoveries as ordinary income.

The typical commercial lawsuit is fraught with multiple claims, requiring courts to sift through the ordinary and capital elements of a complaint and any resulting recovery. On top of this, one of the more nettlesome issues is the requirement (sometimes argued by the Service and sometimes imposed by the courts) that a sale or exchange occur. The authorities on this point are ultimately inconclusive. These and other disputes will likely make the tax treatment of business recoveries an important area of developing authority for some time.

Business Litigation Recoveries — The Capital vs. Ordinary Debate Continues to Smolder, Vol. 12, No. 5, The M&A Tax Report (December 2003), p. 2.