NOTE Sausage, Specificity, and Settlement Payments: The Erroneous Elevation of Form over Substance in Freda v. Commissioner

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1 NOTE 263 NOTE Sausage, Specificity, and Settlement Payments: The Erroneous Elevation of Form over Substance in Freda v. Commissioner I. Introduction For tax purposes, it is a well-established principle that litigation awards for lost profits are treated as ordinary income, while awards for damage to capital assets are considered capital recovery or capital gain. 1 Less clear, however, is how courts distinguish between lost profits and damage to capital. 2 When intangible assets are involved, the distinction is even more difficult, as proof of the value of the lost asset may often require a demonstration of lost profits. 3 Freda v. Commissioner illustrates the challenges of determining the taxability of a settlement payment when an intangible asset is at the center of the controversy. 4 In Freda, the U.S. Court of Appeals for the Seventh Circuit determined that a settlement payment for trade secret misappropriation was taxable as ordinary income, not as long-term capital gain. 5 In arriving at this conclusion, the court applied the origin of the claim doctrine, determining that because the original complaint asked for lost profits, the settlement payment represented future ordinary income. 6 Not only was the court s reasoning excessively formalistic, but it did little to clarify the existing body of law on taxation of settlement payments involving intangible assets. This Note argues that the Freda court, in applying the origin of the claim doctrine to determine whether a settlement payment should be taxable as ordinary income or as capital gain, focused too narrowly on the precise language of the pleadings, effectively elevating form over substance. Instead, the court should have more accurately reflected economic reality by allocating the disputed payment proportionally between ordinary income and capital gain. Two practical legal implications have arisen from the Freda court s decision and the confused body of law on settlement payment taxation, particularly when intangible assets are involved. First, pleadings and settlement agreements should describe all damages requested with specificity. Second, 1 See I.R.C. 61, 1221, 1222; Rev. Rul , C.B. 14; Rev. Proc , C.B. 659; see also Kenneth W. Gideon, Lawsuits and Settlements (1995). 2 See, e.g., Hort v. Commissioner, 313 U.S. 28, 31 (1941) (concluding recovery was for lost profits and thus ordinary income); State Fish Corp. v. Commissioner, 48 T.C. 465, 477 (1967) (concluding recovery was for damage to capital asset and thus capital gain). 3 See Gideon, supra note 1, at Freda v. Commissioner, 656 F.3d 570 (7th Cir. 2011). 5 at at

2 264 SECTION OF TAXATION pleadings and settlement agreements should allocate precise amounts to lost profits and to damage of capital. Part II of this Note summarizes the relevant background law regarding the taxation of settlement payments in controversies involving intangible assets. Part III provides an overview of Freda. Part IV argues that the court s application of the origin of the claim doctrine elevated form over substance and instead should have allocated the settlement payment between ordinary income and capital gain in the proportions that best reflect economic reality. Part IV also suggests two practical legal implications stemming from Freda and other relevant decisions. II. Background Under the origin of the claim doctrine, the tax consequences of settlement proceeds are determined by the nature of the claim and the actual basis of recovery. 7 Therefore, courts must ask: In lieu of what were the damages awarded? 8 The U.S. Supreme Court mandated the origin of the claim analysis in United States v. Gilmore to distinguish between deductible and nondeductible litigation expenses. 9 Since Gilmore, courts have utilized the doctrine to determine whether proceeds from a lawsuit or settlement are taxable as ordinary income or as capital gain. 10 An award for lost profits is taxable as ordinary income. 11 An award for damage to an asset is considered a return of capital to the extent of the basis in the asset, with the excess amount over basis treated as gain under section When an intangible asset under section 197 is implicated, 13 judicial application of the origin of the claim doctrine has led to conflicting outcomes. 14 Inherent valuation difficulties arise because proving damage to an intangible asset often amounts to demonstrating the extent to which profits were lost Sager Glove Corp. v. Commissioner, 36 T.C. 1173, 1180 (1961), aff d, 311 F.2d 210 (7th Cir. 1962). 8 See, e.g., Raytheon Prod. Corp. v. Commissioner, 144 F.2d 110, 113 (1st Cir. 1944). 9 United States v. Gilmore, 372 U.S. 39, 49 (1963) ( [T]he origin and character of the claim with respect to which an expense was incurred... is the controlling basic test of whether the expense was business or personal and hence whether it is deductible or not.... ). 10 See I.R.C. 61, 1221, 1222, 1231; see also Gideon, supra note 1, at Lawsuit and settlement payments are treated similarly for tax purposes. See, e.g., Estate of Longino v. Commissioner, 32 T.C. 904, (1959). 11 See 61; Sager Glove, 36 T.C. at 1180 ( If the recovery represents damages for lost profits, it is taxable as ordinary income. ). Under the substitute for ordinary income doctrine, a payment in exchange for future ordinary income is ordinary income. See Commissioner v. P.G. Lake, Inc., 356 U.S. 260, (1958). 12 See 1231; Bresler v. Commissioner, 65 T.C. 182, 184 (1976) ( [D]amages for injury to capital assets... are taxable as capital gain to the extent of any excess over basis. ); Sager Glove, 36 T.C. at 1180 ( [I]f it represents a replacement of capital destroyed or injured, the money received... is a return of capital and not taxable. ). 13 See I.R.C Trade secrets are intangible assets. 197(d)(1)(C)(iii). 14 See infra notes and accompanying text. 15 See Gideon, supra note 1, at 148.

3 NOTE 265 There exists an imprecise but important distinction between damages measured by profits and damages for lost profits, 16 or expressed differently, the right to earn income and the right to earned income. 17 This distinction was articulated by the U.S. Court of Appeals for the Fifth Circuit in United States v. Dresser Industries, Inc., a case involving the transfer of rights to a patent in exchange for a monetary payment. 18 In concluding that the payment was taxable as capital gain, the court emphatically distinguished the vast difference between the future right to earn income and the future right to earned income. 19 In response to the Commissioner s argument that the taxpayer merely received the right to future ordinary income in exchange for the patent, the Dresser Industries court stated: The fact that the income which could be earned would be ordinary income is immaterial; such would be true of the sale of all income-producing property. 20 This substitute for ordinary income doctrine that a payment in exchange for the right to future ordinary income is ordinary income has recently been reaffirmed in numerous courts. In Lattera v. Commissioner, for example, the U.S. Court of Appeals for the Third Circuit adopted its own substitute-for-ordinary-income analysis to conclude that a payment received by the taxpayers in exchange for the right to future, remaining payments of their lottery prize was subject to ordinary income treatment. 21 The same result was reached in Womack v. Commissioner, where the Tax Court held that gain from the sale of the right to receive future annual lottery payments was taxable as ordinary income. 22 Case law has defined the application of the origin of the claim doctrine. Perhaps the most generous allowance for capital gain treatment occurred in Farmers & Merchants Bank of Catlettsburg, Kentucky v. Commissioner. 23 The taxpayer complained that the Federal Reserve collected payments in such an unusual and unprofessional manner that it interfered with the taxpayer s business. 24 While the taxpayer alleged both loss of earnings and damage to goodwill, the court found that the gravamen of the taxpayer s action against the Reserve Bank was the injury inflicted to its banking business generally and that loss of earnings was merely evidence of the worth of the business See Gideon, supra note 1, at United States v. Dresser Indus., Inc., 324 F.2d 56, 59 (5th Cir. 1963). 18 at See id. at 59 ( There is, in law and fact, a vast difference between the present sale of the future right to earn income and the present sale of the future right to earned income. If an asset will not in the future be useful, or capable of earning income, it is worthless in the business world. ). 20 See id. 21 Lattera v. Commissioner, 437 F.3d 399, 410 (3d Cir. 2006). 22 Womack v. Commissioner, 92 T.C.M. (CCH) 410, 414, 2006 T.C.M. (RIA) , at Farmers & Merchants Bank of Catlettsburg, Ky. v. Commissioner, 59 F.2d 912 (6th Cir. 1932). 24 at

4 266 SECTION OF TAXATION Since Farmers & Merchants Bank, courts have been less inclined to ignore requests for lost profits and treat the entire award as capital gain, frequently placing the burden on the taxpayer to show that the entire award should not be taxed as ordinary income. 26 While a few decisions have found an award to represent damage to a capital asset, 27 others have focused on requests for lost profits, finding the entire award taxable as ordinary income. 28 Other courts have allocated the award amount between ordinary income and capital gain. 29 Because the facts of these cases are often indistinguishable, difficulties arise in determining the tax classification of settlement payments involving intangible assets. III. Freda v. Commissioner In 2011, the U.S. Court of Appeals for the Seventh Circuit addressed the issue of whether a settlement payment for an alleged trade secret misappropriation was taxable as ordinary income or capital gain in Freda v. Commissioner. 30 Part III.A reviews the factual and procedural background of the case. Part III.B discusses the court s reasoning and holding. A. The Facts and Procedural History C & F Packing Co., Inc. (C&F), an S corporation organized in Illinois, supplies uncooked sausage to pizza vendors. 31 C&F worked many years to successfully develop its own process for making high-quality sausage, which it treated as a trade secret. 32 In 1985, Pizza Hut, Inc. (Pizza Hut) offered to enter into a long-term supply contract with C&F where Pizza Hut would 26 See Robert W. Wood, Tax Treatment of Business Litigation Recoveries: Capital Gain vs. Ordinary Income, 99 J. Tax n 27, 29 (July 2003). 27 See, e.g., Inco Electroenergy Corp. v. Commissioner, 54 T.C.M. (CCH) 359, T.C.M. (P-H) 87,437 (1987); State Fish Corp. v. Commissioner, 48 T.C. 465 (1967). 28 See, e.g., Sager Glove Corp. v. Commissioner, 311 F.2d 210 (7th Cir. 1962); Mathey v. Commissioner, 177 F.2d 259 (1st Cir. 1949). 29 See, e.g., Gail v. United States, 58 F.3d 580, 585 (10th Cir. 1995); Durkee v. Commissioner, 162 F.2d 184, 187 (6th Cir. 1947); Healthpoint, Ltd. v. Commissioner, 102 T.C.M. (CCH) 379, 383, 2011 T.C.M. (RIA) , at 1649; Collins v. Commissioner, 18 T.C.M. (CCH) 756, 763, T.C.M. (P-H) 59,174, at 660 (1959); Jay C. Morse Trust, The Cleveland Trust Co., Tr. v. Commissioner, 6 T.C.M. (CCH) 855, 861, T.C.M. (P-H) 47,204, at 739 (1947). 30 Freda v. Commissioner, 656 F.3d 570, (7th Cir. 2011). 31 Freda v. Commissioner, 98 T.C.M. (CCH) 120, 121, 2009 T.C.M. (RIA) , at According to C&F s website, the family-owned and operated company has grown since 1945 to become one of the largest independent producers of custom private label sausage products, pizza toppings, and other meat products in the United States. Custom Manufacturers of Quality Food Products, C&F Packing Company, last accessed Oct. 15, 2014, cfpacking.com. 32 In 1985, C&F successfully patented its process for making precooked sausage look and taste like homemade sausage. After receiving the patent, C&F continued to improve the process, and it treated both the process and the improvements as a trade secret. Freda, 98 T.C.M. (CCH) at , 2009 T.C.M. (RIA) at

5 NOTE 267 purchase at least half of its sausage supply from C&F, with a guaranteed floor of 200,000 pounds per week, if C&F would share its trade secret with Pizza Hut. 33 The parties executed an agreement that required, inter alia, C&F to disclose its trade secret to Pizza Hut and Pizza Hut to keep the information confidential. 34 Ultimately, Pizza Hut refused to enter into the long-term supply contract with C&F, and C&F s sales to Pizza Hut decreased considerably. 35 In 1992, C&F learned that Pizza Hut had unlawfully disclosed its trade secret to IBP, Inc. (IBP), a C&F competitor, and that Pizza Hut was buying the majority of its sausage from IBP. 36 C&F filed a complaint against IBP in the U.S. District Court for the Northern District of Illinois. Amending the complaint twice, C&F added multiple claims against both IBP and Pizza Hut, including a claim against each for trade secret misappropriation. 37 The misappropriation claim against Pizza Hut alleged that as a result of Pizza Hut s actions, C&F has been damaged, and has suffered, among other things, lost profits, lost opportunities, operating losses and expenditures. 38 C&F requested compensatory damages, punitive damages, an injunction, attorney s fees, and [s]uch other and further relief as this Court and/or jury may deem proper and just. 39 The district court dismissed all except the misappropriation claim against IBP, for which a jury awarded C&F $10.94 million. 40 The judgment was affirmed by the U.S. Court of Appeals for the Federal Circuit. 41 After paying its attorney s fees and making other required payments, 42 C&F retained $4.01 million. 43 Determining that $2.86 million of the award represented lost profits, C&F reported that amount as ordinary income on its 2000 federal tax return. 44 It reported the remaining $1.15 million as capital gain, receiving no objection from the Commissioner. 45 While the Federal Circuit had affirmed the jury s award of damages by IBP, it reversed and remanded the district court s dismissal of C&F s trade at C&F had entered into several agreements disclosing its trade secret to certain other meat suppliers of Pizza Hut in exchange for promises of confidentiality; however, IBP was not one of them. 37 See id. C&F brought other claims against IBP and Pizza Hut for fraud, breach of fiduciary duty, unfair competition, unjust enrichment, patent infringement, and tortious interference with business expectancy. 38 at In 1997, C&F redeemed one-third of the company s stock from stockholder Gerald Freda, pursuant to a shareholder redemption agreement that entitled Mr. Freda to a one-third interest in the lawsuit Freda v. Commissioner, 656 F.3d 570, 572 (7th Cir. 2011). 45

6 268 SECTION OF TAXATION secret misappropriation claim against Pizza Hut. 46 Pizza Hut filed a motion for summary judgment, which was denied by the district court. 47 Then, in 2002, C&F and Pizza Hut entered into a settlement agreement, under which C&F agreed to drop its trade secret misappropriation claim in exchange for a $15.3 million payment by Pizza Hut. 48 After paying its attorney s fees and making other required payments, C&F retained $6.12 million, which it reported as long-term capital gain on its 2002 federal income tax return. 49 The Commissioner determined the $6.12 million should have been reported as ordinary income and issued notices of deficiency to the S corporations. 50 The shareholders filed petitions challenging the Commissioner s determinations in the U.S. Tax Court. 51 When the Tax Court sustained the Commissioner s finding, the shareholders appealed to the Seventh Circuit. 52 B. The Seventh Circuit s Decision On appeal, the shareholders raised two arguments in support of the position that the settlement proceeds were long-term capital gain: first, because they were received by C&F to settle a claim for damage to a capital asset; and second, or alternatively, because they were received by C&F from the sale or exchange of a capital asset. 53 The court rejected both arguments. 54 In rejecting the shareholders first argument, the court applied the origin of the claim doctrine. 55 While the shareholders argued that the settlement payment represented the lost value of the trade secret and thus was taxable as a capital gain, the court found this description too simplistic. 56 Rather, the at C&F filed a 2002 S corporation Schedule D, including $6.12 million from a trade secret sale. In each Schedule K-1 issued to its stockholders, C&F included his or her respective share of C&F s net long-term capital gain, including the $6.12 million payment from the trade secret sale. Each shareholder (at least those who are petitioners in this case), in turn, reported the income as capital gain when filing his or her 2002 Schedule D with Form Freda v. Commissioner, 98 T.C.M. (CCH) 120, 125, 2009 T.C.M. (RIA) , at Freda, 656 F.3d at Brief and Required Appendix for Petitioners-Appellants at 10, 12, Freda v. Commissioner, 656 F.3d 570 (7th Cir. 2011) (No ), 2010 WL , at *16, * In rejecting the shareholders second argument, the court found that the transfer of the trade secret to Pizza Hut was not a sale or exchange under sections 1222 and 1235 because C&F did not give up all of its substantial rights in the trade secret. C&F continued to possess its right to exclude others, as evidenced by its lawsuit against IBP. The court emphasized that the settlement agreement failed to indicate that Pizza Hut believed it was purchasing the trade secret. This Note does not dispute the court s analysis in this regard and instead focuses on the court s analysis of the shareholders first argument. See Freda, 656 F.3d at at at 574.

7 NOTE 269 court reasoned that the settlement payment represented lost profits of C&F and was therefore taxable as ordinary income. 57 In making this determination, the court emphasized the chameleonic nature of trade secret misappropriation claims, stating that injuries by trade secret misappropriation and their respective remedies may take various forms. 58 For this reason, it focused on the language of C&F s complaint in the original lawsuit, which had claimed lost profits, lost opportunities, operating losses and expenditures, and concluded that the shareholders failed to carry their burden to demonstrate that the origin of the claim was not one for lost profits or other ordinary income. 59 The court distinguished cases relied on by the shareholders because C&F sought profits... from the get-go rather than focusing on the damage to or destruction of its capital asset. 60 Ultimately, the Seventh Circuit affirmed the Tax Court s finding that the shareholders failed to carry their burden to show that the settlement payment did not represent damages taxable as ordinary income. 61 IV. Analysis In Freda, the court focused on the term lost profits in C&F s complaint in determining that the settlement payment from Pizza Hut was not taxable as capital gain. 62 Part IV.A argues that the court elevated form over substance by focusing too heavily on the wording of the pleadings and instead should have allocated the settlement payment between ordinary income and capital gain to best reflect economic reality. Part IV.B argues that Freda and other cases constituting the confused law of settlement payment taxation suggest two practical legal implications: first, pleadings and settlement agreements should carefully describe all damages requested with specificity; and second, pleadings and settlement agreements should allocate precise amounts of recovery to both lost profits and damage of capital assets. A. The Court Elevated Form over Substance and Instead Should Have Allocated the Settlement Payment to Best Reflect Economic Reality In focusing almost exclusively on the request for lost profits in the shareholders complaint, the Freda court failed to emphasize substance over form, a 57 at at at at at The dissent opined that the Tax Court had misread C&F s complaint, as lost profits was only one aspect of the damages claimed by C&F. Furthermore, C&F had already received its damages for lost profits from IBP. Thus, concluded the dissent, the entire settlement payment should be taxable as capital gain, as the nature of C&F s claim was a claim seeking compensation for the substantially diminished value inflicted upon the trade secret. at at 575.

8 270 SECTION OF TAXATION well-established legal tax principle. 63 In response to the shareholders argument that because a trade secret was at the center of their claim, the settlement payment was also capital in nature, the court stated that the shareholders argument could [p]erhaps in a different case succeed. 64 Its reasoning, however, implies that such a case could not exist unless a taxpayer carefully excludes the words lost profits from its complaint. Not only did the court distinguish cases relied on by the shareholders because the taxpayers in those cases never alleged an entitlement to lost profits, 65 the court, as the dissent correctly contended, largely ignored the shareholders other requests for among other things... lost opportunities, operating losses, and expenditures, resulting in an incomplete interpretation of the complaint. 66 This formalistic approach by the Freda court fails to recognize the substantive distinction between the right to earn income and the right to earned income, as articulated by Dresser Industries. 67 In Freda, the court s exclusive focus on the shareholders request for lost profits fails to acknowledge the economic reality that C&F not only lost profits, but lost its right to earn future income with the misappropriation of its trade secret. 68 Rather than surveying the economic reality of what C&F lost through Pizza Hut s misappropriation of its trade secret, however, the Freda court formalistically conducted a narrow review of the precise wording of the shareholders complaint, concentrating almost exclusively on the term lost profits. 69 A better approach by the Freda court would have been to allocate the settlement payment proportionally to best reflect economic reality. Such an approach was utilized by the U.S. Court of Appeals for the Tenth Circuit in Gail v. United States. 70 In Gail, a developer had extracted oil and gas from the taxpayer s land without her knowledge or consent. 71 The taxpayer sought damages for royalties and for her share of all other value the developer had derived from her land. 72 The issue was whether the proceeds from the 63 See, e.g., Gregory v. Helvering, 293 U.S. 465, (1935). Ironically, the Freda court explicitly referenced the doctrine of substance over form in justifying its rejection of the shareholders argument. See Freda, 656 F.3d at 573 ( [Shareholders ] broad-brush approach... elevates form over substance, which is generally frowned upon in tax jurisprudence. ). While the court paid lip service to the substance over form doctrine, its decision was not based on substance. Despite its criticism that the taxpayer s request to be bound by the title of the claim would elevate form over substance, the court ultimately relied on the language of the pleadings and the settlement agreement rather than delving into the substance of the case. 64 Freda, 656 F.3d at See id. at See id. at 571, 574, 579. The court expressly denied a belief that C&F solely sought lost profits, yet it still managed to affirm the Tax Court s conclusion that C&F failed to meet its burden to show that the entire payment should not be taxed as ordinary income. See id. at See United States v. Dresser Indus., Inc., 324 F.2d 56, 59 (5th Cir. 1963). 68 See Freda, 656 F.3d at See id. 70 Gail v. United States, 58 F.3d 580 (10th Cir. 1995). 71 at

9 NOTE 271 judgment were for royalties and should be characterized as ordinary income, or whether they were for the diminished value of her land and should be characterized as capital gain. 73 Rejecting the district court s characterization of the entire payment as ordinary income, the Tenth Circuit found that the judgment represented both royalties and diminution to the value of the property. 74 It remanded the case to the district court to allocate the judgment between royalties and diminution in land value, concluding that this approach best reflected economic reality and had obvious equitable appeal. 75 In reaching its conclusion, the Gail court refused to rely solely on the language of the pleadings, rejecting a reliance on magic words in a complaint as overly formalistic. 76 According to the court, [N]otice pleading under the rules of civil procedure and the tax code now emphasize function instead of form, and economic reality rather than labels. 77 The Gail court is correct; both the general relaxation of notice pleading requirements and the doctrine of substance over form contradict the Freda court s singular focus on the term lost profits in the complaint. A similar approach has been employed in numerous other decisions. 78 In Durkee v. Commissioner, the U.S. Court of Appeals for the Sixth Circuit rejected the Tax Court s characterization of a settlement payment for lost profits and damage to goodwill as entirely taxable as ordinary income and remanded to the Tax Court to apportion the payment between ordinary income and capital gain. 79 The Durkee court further emphasized that once the taxpayer demonstrated that the Commissioner s determination was arbitrary and excessive, it was the Tax Court s responsibility, not the taxpayer s, to determine the lawful amounts taxable as income and capital gain. 80 In fact, the Freda court possessed a discernible standard for determining the appropriate proportions of ordinary income and capital gain: the shareholders prior division of the jury award from IBP into ordinary income and capital gain. A similar approach was evident in Healthpoint, Ltd. v. Commissioner at at at See, e.g., Durkee v. Commissioner, 162 F.2d 184 (6th Cir. 1947); Healthpoint, Ltd. v. Commissioner, 102 T.C.M. (CCH) 379, 2011 T.C.M. (RIA) ; Collins v. Commissioner, 18 T.C.M. (CCH) 756, T.C.M. (P-H) 59,174 (1959); Jay C. Morse Trust, The Cleveland Trust Co., Tr. v. Commissioner, 6 T.C.M. (CCH) 855, T.C.M. (P-H) 47,204 (1947). 79 Durkee, 162 F.2d at See id. In Freda, the court questioned the shareholders at oral argument as to why they apportioned the jury award from IBP into ordinary income and capital gain but did not similarly apportion the settlement payment from Pizza Hut. The shareholders asserted that the IBP award was incorrectly allocated and should have been entirely taxable as capital gain. This Note does not support shareholders assertion; however, Durkee indicates that it was the responsibility of the Tax Court, not of the shareholders, to apportion the payment. See Freda v. Commissioner, 656 F.3d 570, 576 n.1 (7th Cir. 2011). 81 Healthpoint, 102 T.C.M. (CCH) 379, 2011 T.C.M. (RIA)

10 272 SECTION OF TAXATION Healthpoint filed two separate lawsuits against Ethex, Ethex I and Ethex II. 82 The Tax Court used allocations from a jury award in Ethex I to determine the tax classification of the settlement proceeds in Ethex II. 83 The Healthpoint court concluded that, although the claims were slightly different, the two cases were very similar and thus the damages should be allocated in similar proportions. 84 Although the jury award and settlement payment in Freda were received from different parties, the same facts and circumstances surrounded both payments. 85 The Freda court, or the Tax Court on remand, should have utilized the allocations from the IBP award, uncontested by the Commissioner, 86 as a standard for allocating the settlement payment from Pizza Hut. B. Implications for Legal Practice Two practical legal implications arise from Freda and the related case law. First, pleadings and settlement agreements should describe all damages requested with specificity. Second, pleadings and settlement agreements should allocate precise amounts of recovery to both lost profits and to damage of capital assets. While these steps may not eliminate the difficulties inherent in determining the taxability of the proceeds of litigation, they are simple steps within the taxpayers control that will increase their likelihood of a favorable judicial decision if challenged by the Service. 1. Pleadings and Settlement Agreements Should Describe All Damages Requested with Specificity The predominant lesson from Freda is the necessity of describing all damages requested with specificity when drafting pleadings and settlement agreements. The Freda court s focus on the term lost profits in the complaint demonstrated an overly formalistic application of the origin of the claim doctrine. Freda, however, is not an isolated instance of a formalistic court. Numerous opinions in various courts have made clear that the language utilized beginning in the earliest stages of litigation is crucial in determining the origin of a claim for tax classification purposes. 87 In State Fish Corp. v. Commissioner, for example, the Tax Court determined that a settlement payment represented damage to goodwill, rather than lost profits, by literally counting the number of times each was referenced in the complaint and finding that references to damage to goodwill outnumbered 82 at 380, 2011 T.C.M. (RIA) at at , 2011 T.C.M. (RIA) at at 383, 2011 T.C.M. (RIA) at Freda, 656 F.3d at See id. 87 See, e.g., Sager Glove Corp. v. Commissioner, 311 F.2d 210, 212 (7th Cir. 1962); Mathey v. Commissioner, 117 F.2d 259, 263 (1st Cir. 1949); Healthpoint, 102 T.C.M. (CCH) 379, 2011 T.C.M. (RIA) ; Inco Electroenergy Corp. v. Commissioner, 54 T.C.M. (CCH) 359, T.C.M. (P-H) 87,437 (1987); State Fish Corp. v. Commissioner, 48 T.C. 465 (1967).

11 NOTE 273 references to lost profits ten to one. 88 The court also compared the language of the taxpayer s complaint to the language of the complaint in Farmers & Merchants Bank 89 to confirm that the taxpayer presented a strong case that the claim was for damage to goodwill. 90 The Tax Court s sole focus appears to be on the precise language of the taxpayer s original complaint, not unlike the Seventh Circuit in Freda. In Inco Electroenergy Corp. v. Commissioner, the Tax Court found that a settlement payment was taxable as capital gain because the wording of the documents filed in the trademark proceedings centered on the potential damage to the taxpayer s trademark and goodwill. 91 The court emphasized that the taxpayer never alleged it was entitled to lost profits; rather, the subject of lost profits only arose in an attempt to place a value on the damage to the trademark and goodwill. 92 In reaching its conclusion, the court cited State Fish for the proposition that it should rely heavily on the language of the allegations set forth in the pleadings. 93 Thus, taxpayers would likely benefit from precisely describing, beginning in the earliest stages of litigation, any and all damage to capital assets they have suffered. 2. Pleadings and Settlement Agreements Should Allocate Precise Amounts of Recovery to Lost Profits and to Damage of Capital Assets Another lesson from Freda is that pleadings and settlement agreements should, when possible, allocate precise amounts of recovery to both lost profits and damage of capital assets. Courts have frequently expressed frustration with taxpayers lack of allocations. 94 The Freda court may certainly have reached a different conclusion if the shareholders had themselves allocated a portion of the settlement payment as lost profits, as they had apportioned the jury award from IBP. While, as iterated in Durkee, it is not a taxpayer s responsibility to determine the amount he is overcharged by the Commissioner, 95 it seems that it could only help support his case for the tax consequences of his damages to initially allocate them himself. According to the Healthpoint court, express alloca- 88 See State Fish, 48 T.C. at 474 ( [W]e have carefully examined the complaint... and have concluded that 10 of its 24 numbered paragraphs are directly concerned with damage to the goodwill of the business while only one such paragraph is directly concerned with lost profits. ). 89 Farmers & Merchants Bank v. Commissioner, 59 F.2d 912 (6th Cir. 1932). 90 See State Fish, 48 T.C. at Inco Electroenergy, 54 T.C.M. (CCH) 359, T.C.M. (P-H) 87,437 (1987). 92 See id. at See id. 94 See, e.g., Collins v. Commissioner, 18 T.C.M. (CCH) 756, 763, T.C.M. (P-H) 59,174, 660 (1959) ( At this point we encounter difficulty. There is no allocation in the agreements themselves, and the record does not furnish a basis for an accurate allocation. Yet, believing that some amount should be allocated to damage to capital, we think we must make the best estimate which we can. ). 95 See Durkee v. Commissioner, 162 F.2d 184 (6th Cir. 1947).

12 274 SECTION OF TAXATION tions in settlement agreements will generally be observed for tax purposes so long as the agreement was entered into by the parties in an adversarial context at arm s length and in good faith. 96 Based on economic reality, in most controversies involving intangible assets, litigation awards will consist of some combination of both lost profits and damage to the asset. To assist a formalistic court in reaching the outcome that best reflects this economic reality, plaintiffs should provide a precise description of both damages in the complaint or settlement agreement. V. Conclusion In Freda, the Seventh Circuit elevated form over substance by focusing too narrowly on the precise language of the pleadings in finding that the disputed settlement payment was taxable as ordinary income. Rather, the court should have allocated the settlement payment between ordinary income and capital gain in a proportional manner best reflecting economic reality. While the Freda court s approach to the origin of the claim doctrine was excessively formalistic, it illustrates the importance of careful tax planning beginning at the earliest stages of litigation. When damage to a trade secret or other intangible asset is alleged, parties should request both lost profits and damage to the asset in precise, unambiguous language. While this may not represent a panacea for the problems associated with determining the taxability of litigation proceeds, it is a simple step within the parties control that will alleviate such challenges. In addition, courts should strive for an outcome that most accurately reflects the economic reality of the circumstances. Often, this will involve an allocation of damages between ordinary income and capital gain, as the claim was likely realistically comprised of both lost profits and damage to the capital asset. Unless parties and courts adopt these practices, the tax consequences of litigation and settlement proceeds will remain a source of uncertainty and virtually endless litigation. Kelsey Moran See Healthpoint, Ltd. v. Commissioner, 102 T.C.M. (CCH) 379, 382, 2011 T.C.M. (RIA) , at 1647 (citing Robinson v. Commissioner, 102 T.C. 116, 126 (1994)). 97 Georgetown University Law Center, J.D. Candidate The author thanks Armando Gomez of Skadden, Arps, Slate, Meagher & Flom for his helpful feedback and the staff of The Tax Lawyer for its editorial contributions.

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