Last year the shareholders of C&F Packing Co. found themselves on the winning side of a trade-secret settlement. Unfortunately, the shareholders also were handed a tax bill along with the award. Once again, a tax-court ruling underscored a lesson corporations still fail to remember: that certain payouts received as a result of a lawsuit are treated as ordinary income for tax purposes.
The case involved C&F, an S corporation in the business of supplying uncooked sausage and other meats to pizza vendors, including Pizza Hut. C&F developed an innovative process for making precooked sausage that had the appearance and taste of home-cooked sausage, and subsequently obtained a patent with respect to this process. As a result of a confidentiality agreement, C&F disclosed to Pizza Hut the sausage-making process. In addition, C&F entered into third-party confidentiality agreements with four suppliers of Pizza Hut to share the trade secret with the suppliers.
In 1989 Pizza Hut disclosed the trade secret to one of its largest meat suppliers at the time, IBP Inc., without informing C&F or acquiring its consent. IBP replicated the C&F process and began to sell to Pizza Hut sausage made with the proprietary process. In turn, Pizza Hut began to buy less sausage from C&F.
C&F filed a claim against Pizza Hut and IBP in which it alleged, among other things, patent infringement as well as misappropriation of trade secrets. Eventually, IBP paid C&F some $10.4 million in damages (which had been awarded to C&F in a jury trial) and, pursuant to a settlement agreement, Pizza Hut paid C&F approximately $15.3 million.
C&F reported the payment (after accounting for attorney contingency fees) from Pizza Hut as a long-term capital gain. By contrast, the Internal Revenue Service determined that the amount Pizza Hut paid to C&F with respect to the settlement agreement was ordinary income and not long-term capital gain. The court agreed with the IRS. (See Freda v. Commissioner, T.C. Memo. 2009-191.)
Nature of the Claim
In support of its capital-gain claim, C&F made three separate arguments, each of which was rejected by the court. Specifically, C&F contended that Pizza Hut paid the amount at issue for:
• Damage to the trade secret, a capital asset in C&F’s hands;
• C&F’s sale or exchange of the trade secret to Pizza Hut; or
• The termination of C&F’s rights under the Pizza Hut confidentiality agreement with respect to the trade secret.
It was agreed that the taxation of a sum received in a lawsuit settlement depends upon two factors: the nature of the claim and the actual basis of recovery. If the recovery represents damages for lost profits, or other items taxed as ordinary income, it is taxable as ordinary income. However, if the recovery represents damages for injury to, or damage of, a capital asset, it is taxable as a capital gain (to the extent it exceeds the taxpayer’s adjusted basis in the asset).
In the C&F case, the parties agreed that the only claim outstanding against Pizza Hut at the time of the settlement agreement was the misappropriation claim. C&F had alleged that as a result of Pizza Hut’s misappropriation, C&F had been damaged and had suffered, “among other things, lost profits, lost opportunities, operating losses, and expenditures.”
The court concluded, however, that C&F had failed to carry its burden of establishing that it specified in the misappropriation claim “lost profits,” etc., solely as a measure of Pizza Hut’s injury to, or damage of, the trade secret. In short, both the nature of the claim and the actual basis of recovery strongly suggested that the payments received from Pizza Hut should be classified as ordinary income. Indeed, the court found that C&F asserted a claim for the items specified as the damage to and the suffering of C&F resulting from Pizza Hut’s misappropriation. Accordingly, C&F failed to carry its burden of establishing that the amount at issue is long-term capital gain.
Sale or Exchange
Based on the Internal Revenue Code (specifically Section 1222), a sale or exchange of a capital asset is an essential prerequisite to capital-gain treatment. For a transfer of a trade secret to qualify as a sale or exchange, the owner must transfer “all substantial rights” to it. Further, in the context of a trade secret, the most significant rights held by the owner are the rights to prevent the unauthorized use and unauthorized disclosure of the trade secret.1
Under the settlement agreement, C&F did not transfer to Pizza Hut any rights to the trade secret, let alone the most significant right. Accordingly, in the absence of a sale or exchange, C&F did not carry its burden of establishing that, under Section 1222, the amount at issue is a long-term capital gain.
Section 1234A states that gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property that is a capital asset is treated as gain or loss from the sale of a capital asset. C&F asserted that the confidentiality agreement gave it the rights to require Pizza Hut to “keep the trade secret confidential,” and that the settlement agreement terminated those contractual rights.
Once again, the court rejected C&F’s claims, concluding that the meat company failed to carry its burden of establishing that Pizza Hut paid the settlement amount for the termination of the rights of C&F under the confidentiality agreement with respect to the trade secret. After all, the court noted, the express terms of the settlement agreement made no mention of the confidentiality agreement.
As a result, the payment received by C&F from Pizza Hut was properly classified as ordinary income. This case is but the latest in a long line of cases that stand for the proposition that the taxation of payments derived from a lawsuit, or from the settlement thereof, will be governed exclusively by the nature of the claims asserted in the suit and the actual basis of recovery. If the documentation regarding the nature of the claim and the basis of recovery is not prepared with great care and precision, the taxpayer will be unable — except in rare and extraordinary cases — to escape the tax consequences that flow from the transaction.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See Rev. Rul. 71-564, 1971-2 C.B. 179. Transfer of a trade secret constitutes an “exchange” if the term lasts until the trade secret becomes public knowledge and is no longer protectable under local law in the country of use. (See Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, Para. 3.03.)