The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 2, September 2002, Panel Publishers, New York, NY.


By Robert W. Wood

Suppose you've just completed an acquisition, and find that everything is not as you thought it was. Litigation ensues. Eventually, you recover part of the purchase price. Should this recovery be treated as a reduction in purchase price (thus adjusting the price previously paid)? Should it be treated as a recovery of basis and therefore not as income? Does it matter how you plead your case? Does it matter if the tax year for the acquisition is now closed? Does it matter if you still hold the acquired company or have (by the time of the recovery) already disposed of it? Should you be lucky enough to recover more than the purchase price, is the excess ordinary income or capital gain?

I cannot hope to answer all of these questions, even if given more space than The M&A Tax Report format allows. Still, we can do more than scratch the surface of this important and nettlesome area. I've long been saying that the tax treatment of damage awards and settlement payments is becoming more and more critical. Although it is still the province of tax professionals, I encounter more litigants (and their lawyers) who display at least a modicum of sensitivity to tax issues in this context.

It's easy to see why. The swings between ordinary income treatment (the traditional lost profits approach the IRS loves) and capital treatment (a favorite of taxpayers) can be significant for those taxpayers entitled to rate preferences. At the moment that does not encompass corporations, and some large corporations erroneously think that the ordinary income vs. capital gain distinction is of little moment. On the contrary, characterization questions are still highly important, especially since a recovery of basis can seem like a freebie.

One of the classic debates is whether a recovery constitutes ordinary income or capital gain. In the vast majority of cases, taxpayers want to argue for capital gain treatment, while the government (not surprisingly) is nearly always better off arguing ordinary income. It is up to the taxpayer to make the case for capital gain treatment. Apart from the usual origin of the claim type issues, an important issue is whether the taxpayer also must show that there was a sale or exchange to qualify for capital gain treatment.

Muddled Flap

There is conflicting authority on the sale or exchange requirement. The Internal Revenue Service, and the Tenth Circuit have ruled that there must also be an underlying sale or exchange in order to qualify for capital gains treatment. The Tax Court is muddled on this issue. Still, the IRS views are troubling.

In Revenue Ruling 74-251, 1974-1 C.B. 234 (1974), the Revenue Service ruled that acceptance of payments in settlement of claims in a lawsuit does not constitute a sale or exchange. The ruling states that "[u]nless it can be clearly established that there has been a sale or exchange of property, money received in settlement of litigation is ordinary income. The mere settlement of a law suit does not in itself constitute a sale or exchange."

This ruling, however, involved a unique set of facts, and arguably doesn't have universal application. It probably should not be read either to require a sale or exchange in every case and/or to negate a settlement constituting a sale or exchange in every case.

It is more troublesome that the Tax Court has explicitly required sale or exchange treatment, although the decisions typically arise when a taxpayer argues that settlement of a lawsuit itself constitutes a sale or exchange. Very recently, in Steel v. Commissioner, T.C.Memo. 2002-113 (2002), the taxpayers (through a series of transactions) conveyed and then re-acquired interests in a lawsuit in connection with a business sale. When the lawsuit settled, the taxpayers treated the income as additional payments from the stock sale and reported it as capital gain. The court said it was ordinary, noting:

"[N]ot every gain growing out of a transaction concerning capital assets is allowed the benefits of the capital gains tax provision. Those are limited by definition to gains from 'the sale or exchange' of capital assets. A sale or exchange must be shown for a taxpayer to receive long-term capital gain treatment." (Citations omitted.)

Similarly, in Nahey v. Commissioner, 111 T.C. 256 (1998), a corporate taxpayer acquired pending lawsuits in the context of a asset acquisition. When the lawsuit settled, the taxpayer reported the settlement as long term capital gain (without allocating any basis to the claim). The Tax Court stated that "[a] sale or exchange is a prerequisite to the rendering of capital gain treatment." Id. at 262. It reasoned that since the taxpayer's rights vanished when the lawsuit settled, it could not have sold or exchanged anything. The court therefore held the settlement was ordinary income. Id. at 266.

In Kempter v. Commissioner, T.C. Memo. 1963-68 (1963), the Tax Court indicated that the burden of proof on the taxpayer in the settlement of a lawsuit over the ownership of an oil and gas lease was to show that the settlement constituted a sale or exchange under § 1222 of an interest in the lease or a capital replacement. The court found that the settlement agreement reflected the extinguishment of an unrecognized claim against property and the settlement of a claim against income, neither of which was sufficient to support treating the recovery as a capital gain.

The Tax Court is not the only court to have spoken on this. The compromise settlement of amounts claimed for services rendered under a government construction contract was held by the Tenth Circuit in Sanders v. Commissioner, 225 F.2d 629 (10th Cir. 1955), cert. denied 350 U.S. 967 (1956), not to constitute a sale or exchange since the money would have been taxed as ordinary income for services rendered if it had been collected when it was originally due. The court noted that the character of the income is not changed regardless of the intervening time between performance of the services and recovery through a lawsuit or compromise settlement.

Better News

Fortunately, although some of these decisions are troubling, there is some better news in this area, too. The Tax Court (and even one appellate court) has not taken the rigid "you have to sell it" attitude when it comes to litigation recoveries. In Turzillo v. Commissioner, the Sixth Circuit reversed the Tax Court's determination to find that the settlement and release of a suit relating to the contractual rights of a former employee to purchase stock in the employer corporation was a surrender of property rights in exchange for money, affording capital gains treatment since there was a sale or exchange.

In other decisions involving a clear injury to a distinct capital asset, however, the Tax Court has allowed capital gain treatment even when there was no sale or exchange and without even raising the issue. For example, in Inco Electroenergy Corp. v. Commissioner, TC Memo 1987-437 (1987), the taxpayer sued Exxon for infringing on one of its existing trademarks. Exxon agreed to pay the taxpayer $5 million in damages, and the taxpayer continued to use the trademark. In analyzing the origin of the claim, the court stated that "amounts received for injury or damage to capital assets are taxable as capital gains, whereas amounts received for lost profits are taxable as ordinary income."

The court first found that the claim was for damages to the trademark and associated goodwill. It then stated that "we need only to characterize the nature of these assets," which it found were capital assets. It therefore ruled that the award was taxable as capital gain. It did not mention a sale or exchange requirement.

Similarly, in State Fish Corporation v. Commissioner, 48 TC 465 (1967), the taxpayer purchased all the assets of a company including its goodwill. The seller violated a non-compete agreement, and the taxpayer sued claiming injury to its goodwill. Although there was no sale or exchange of the goodwill, the court ruled that the award constituted a tax free recovery of basis.

IRS Consistency?

No one ever said the IRS had to be consistent. Still, consistency is nice, and this is a terribly important area. Unless one argues that basis recoveries and capital gain characterization ought to be limited to damage to one's home, there is considerable inconsistency. Consider the Service's position in some of the litigation recovery cases vs. a series of published and private rulings involving homeowners associations and injury to property. The IRS has allowed return of basis and capital gain characterization when homes were injured even though there was no sale or exchange.

Take Revenue Ruling 81-152, 1981-1 C.B. 433. There, a condominium management association recovered an award against a developer for defects in the units. No sale or exchange of a capital asset was involved. The IRS ruled that the award was received on behalf of individual unit owners. The ruling concludes that the proceeds represent "a return of capital to each unit owner to the extent the recovery does not exceed that owner's basis in his or her property interest in the condominium development." The ruling also notes that the unit owners must reduce their individual bases in the property by their share of the award.

Similarly, in Letter Ruling 9335019 (1993), a homeowners association brought a claim for damages against developers for construction defects. In analyzing the origin of the claim, the IRS ruled that the proceeds "represent amounts to repair or restore the property that the builder agreed would be properly constructed." As a consequence, the IRS held that the settlement payments "are not income to the unit owners, but instead represent a return of capital to each unit owner to the extent each unit owner's portion of the recovery does not exceed that owner's basis in his or her property interest." The IRS instructed the unit owners to reduce their bases by the amount of their share of the recovery.

In Letter Ruling 9343025 (1993), a homeowners association settled a claim against a developer and county for injury to common roads and land relating to housing developments. Although there was no sale or exchange of any capital asset, the IRS ruled that because the funds were intended to mitigate against expected damage to the developments, "the receipt of the settlement proceeds represents a return of capital to the Association's unit owners to the extent that each unit owner's portion of he recovery does not exceed that owner's basis in his or her property interest."

Most Recent Mess

Let's go back to where we started, with the most recent case to confront this issue. The Tax Court decided Mark J. Steel, et al. v. Commissioner, T.C. Memo 2002-113, Tax Notes Doc. No. 2002-10804 (May 6, 2002). There, the court seemed to lay down a uniform rule that a sale or exchange is required for capital gains treatment. The court noted that the settlement there was ordinary income because resolution of a lawsuit is simply not a sale or exchange — even though the lawsuit in question was purchased in an acquisition! The Tax Court refused to construe two couples' receipt of settlement proceeds as capital gains from the sale of stock, finding instead that the funds were taxable as ordinary income.

General partners Mark Steel, Odd-Bjorn Huse, and Bjorn Nymark formed Bochica Partners to acquire the stock of Birting Fisheries Inc. (BFI). The men were the directors and shareholders of BFI, which bought an insurance policy on a commercial fishing vessel. BFI filed a lost-profits claim under the policy, and reported the partial insurance payment as ordinary income. A dispute arose, and BFI sued the insurer for the balance of its claim. BFI sold its stock to Norway Seafoods A/S, and the partners consented to the assignment of BFI's lawsuit to Ottar Inc. for the benefit of themselves as Bochica's partners. Bochica used its entire basis to compute its gain from the BFI stock sale. Steel and Huse recognized gain from the sale as part of their distributive share from Bochica.

The insurer made a payment on the balance of the insurance claim, which was distributed to the general partners. The suit was later settled for $1.5 million. The Huses and the Steels reported their amounts as long-term capital gains on their individual tax returns. The IRS determined that the source of the proceeds from the insurance company was the settlement of the lawsuit and that the funds weren't received as part of a sale or exchange.

Tax Court Judge Robert P. Ruwe held that the settlement proceeds were ordinary income, not additional consideration from the sale of their stock. Thus, the couples received less favorable tax treatment of the funds they received. The court explained that the settlement of a lawsuit isn't a sale or exchange under Section 1222(3)'s provision on capital gains taxation. The court rejected the couples' argument that they received the lawsuit in exchange for their stock, finding instead that the agreement assigning the lawsuit from BFI to the partners contemplated a distribution of any lawsuit proceeds before the stock sale transaction. Thus, the court concluded that the form of the assignment was a distribution from BFI to the partners, not a transfer by Norway Seafoods to the partners for their stock.

The court also rejected the couples' argument that the distribution and stock sale transaction should be integrated or characterized as interdependent. The court concluded that, while the two events were related, the distribution wasn't designed as a financing tool to allow for the stock sale.

Last Word

I wish it were possible to give a succinct and tidy conclusion to this mess. Taxpayers generally are going to be aggressive when faced with this kind of conflicting authority. At least aggressive taxpayers are. But even for aggressive taxpayers, it is troubling not to be able to give more definitive guidance. How likely is it that they will prevail on their recovery of basis/capital gain argument? Is the line of cases that is favorable to taxpayers (including the classic State Fish case) explainable by the lack of focus the IRS and courts have given this issue when only a recovery of basis is involved (and not a recovery in excess of basis)?

You see, we conclude just like we began, with a list of questions!

Acquisition Litigation: Must There Be A Sale Or Exchange For Capital Treatment?, Vol. 11, No. 2, The M&A Tax Report (September 2002), p. 1.