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).