Short Summary:
Petitioner Raytheon Production Corporation (Raytheon) came into existence through a series of tax-free reorganizations. The “original” Raytheon was a pioneer manufacturer of a rectifying tube that allowed a radio receiving set to be operated on alternating current instead of on batteries. The Radio Corporation of America (RCA), through its many patents and licensing agreements with companies such as General Electric and Westinghouse, effectively claimed control over almost all of the practical radio circuits.
RCA developed a competitive tube to Raytheon’s, and soon began to require its licensees to purchase tubes from RCA. Ultimately, Raytheon was unable to market its product and brought an anti-trust lawsuit against RCA. Raytheon argued that RCA successfully conspired to destroy its well-established business and valuable goodwill through a monopoly, and that Raytheon had suffered damages in excess of $3,000,000.
In the meantime, RCA sued Raytheon for nonpayment of royalties based on a previous licensing agreement between the two parties. The suit returned a $410,000 judgement in RCA’s favor. During negotiations for settlement of all claims between Raytheon and RCA, the parties agreed to a payment from RCA to Raytheon, in the amount of $410,000. Included in the settlement agreement were licensing rights and sublicensing rights to approximately thirty patents. The settlement agreement did not clarify the amount paid for the patent rights, and the amount paid to settle the anti-trust action.
Of the $410,000 received, Raytheon included $60,000 in its federal income tax as income from patent licenses. Raytheon treated the other $350,000 as a non-taxable return of capital. The Commissioner of Internal Revenue (Commissioner) concluded that the $350,000 was taxable income as the total settlement amount was never apportioned between payment for patent rights and damages.
Key Issue:
Whether an amount received by a taxpayer in compromise settlement of a suit for damages under the Federal Anti-Trust Laws is a non-taxable return of capital or income under IRC § 22(a) (1936)?
Primary Holding:
Because the suit was to recover damages for the destruction of goodwill only (the other business assets were not destroyed but used in Raytheon’s new business), the $410,000 recovery represents a return of capital. However, to the extent the recovery exceeds the basis of the original Raytheon’s goodwill (which is the current Raytheon’s basis acquired through the series of tax-free reorganizations), the excess is considered taxable income.
Key Points of Law:
- IRC § 22(a) (1936) provides that gross income “includes gains, profits, and income … of whatever kind and in whatever form paid … derived from any source whatever.”
- Damages recovered for violations of the anti-trust acts are treated as taxable ordinary income where they represent compensation for lost profits. See Elec. Supply Co. v. Commissioner, 8 B.T.A. 986 (1927).
- The reason for such treatment rests on the well-established rule that profits are taxable income and as the profits’ substitute, the proceeds of litigation are taxable in a like manner.
- Where the suit is for injury to goodwill, the recovery represents a return of capital and, with certain limitations, is not taxable. See Farmers’ & Merchs.’ Bank v. Commissioner, 59 F.2d 912 (6th Cir. 1932).
- However, compensation for the loss of goodwill in excess of the cost, or other, basis is gross income.
- Courts have ruled that in the absence of evidence of the basis of a business and its goodwill, so that the basis that may be assigned is wholly speculative, the gain has been held to be entirely conjectural and not taxable. See Strother v. Commissioner, 55 F.2d 626 (4th Cir. 1932); Farmers’ & Merchs.’ Bank v. Commissioner, 59 F.2d 912 (6th Cir. 1932).
Insight:
The test to determine the treatment of damages recovered, through litigation or settlement, is: In lieu of what were the damages awarded? The Court makes clear that a lawsuit ending in a settlement, does not change the nature of the recovery – damages awarded as a result of litigation and money acquired through a settlement are assessed in the same way. To determine the tax treatment of proceeds generated by the settlement, one must look to the underlying nature of the basis claim from which the settlement amount was realized. Here, the basis claim was for the destruction of goodwill, and for which recovery is, with some limitation, treated as a non-taxable return of capital.
