Tax Court denies taxpayer’s attempt to recharacterize punitive damages as ordinary income

Oct 11, 2011   

In Healthpoint Ltd. v. Comr., T.C. Memo 2011-241 (10/3/11), available here, the Tax Court held that a company could not rely on a settlement agreement to recast a jury award and settlement to avoid paying taxes at ordinary income rates.

The taxpayer filed suit against a rival company and received a jury verdict of $16.47 million, awarding actual damages ($5 million), punitive damages ($3,174,515), disgorgement of profit ($1,640,000), and Lanham Act enhanced damages ($6,349,030). While litigation was pending, the taxpayer filed suit against the same company on different grounds, however, both parties agreed to settle both law suits for $12 million and $4.5 million, respectively.

The parties allocated damages in the settlement agreement differently than the jury’s allocation.  In particular, the settlement agreement provided for no punitive damages, even though the jury had awarded punitive damages in the first suit.  As a result, the taxpayer reported $14.5 million in long-term capital gain and $1.8 million in ordinary income. The IRS conceded that the Lanham Act enhanced damages, which totaled $6,349,030 for loss of goodwill, are taxable as long-term capital gain. However, the IRS challenged the remaining allocations in the settlement agreement.

The Tax Court held that damages were not to be allocated in accordance with the parties settlement agreement but, rather, in accordance with the jury verdict in the first law suit.  The Tax Court determined that proceeds of a settlement agreement attributable to goodwill or damage to reputation are taxable as capital gains, but those determined to be lost or disgorged profits and/or punitive damages are taxable as ordinary income.   The court stated that normally express allocations in settlement agreements will be followed in determining tax consequences.  However, there is an exception if the settlement agreement is not entered into in an adversarial context, at arm’s length, or not in good faith.

The Tax Court ultimately held that damages should be allocated in accordance with the jury verdict because the verdict accurately reflected the economic realities versus the settlement agreement.

The attorneys at Fuerst Ittleman, PL have extensive experience structuring settlement agreements and litigating against the IRS in the event that a settlement agreement is not respected.  If you can contact an attorney by emailing us at: contact@fidjlaw.com.