An August 25, 2009 ruling of the United States Tax Court focused on the tax aftermath of a large recovery for infringement of intellectual property rights. The good news for the innovative company is that it recovered substantial sums for infringement of its rights. The bad news is that its failure to plan ahead left its shareholders liable for tax on considerably more income than they had reported on their tax returns.

In 1984, C&F Packing Company, an Illinois food processing company, developed a process to improve the appearance and taste of precooked sausage. It applied for a patent on its process in 1985, and the patent later issued. Along the way, C&F also developed trade secrets related to improvements to its patented process.

Pizza Hut wasted no time in seeking to use the C&F process. It met with C&F in July 1985. Its representatives declined an offer to license the patent on a royalty-bearing basis, but promised to enter into a long-term supply agreement with C&F that would include minimum annual purchases of 200,000 pounds of sausage.

There were two conditions attached to this offer: First, C&F must disclose its trade secrets to other Pizza Hut suppliers; and second, C&F must refrain from selling to Pizza Hut’s competitors. In August 1985, the parties entered into a confidentiality agreement, and C&F disclosed its trade secrets to several other Pizza Hut suppliers.

Pizza Hut’s orders from C&F never reached 200,000 pounds annually, and it quickly began to insist on more onerous terms in its purchase orders.

In 1989, Pizza Hut disclosed the C&F trade secrets to IBP, another Pizza Hut supplier, without C&F’s consent, in violation of the confidentiality agreement. C&F became certain of this violation in 1993, when its representatives inspected the IBP production facility. C&F promptly sued Pizza Hut and IBP, alleging patent infringement, fraud, unfair competition and misappropriation of trade secrets.

In its complaint, C&F stated that, as a result of the defendants’ misdeeds, C&F had suffered “lost profits, lost opportunities, operating losses and expenditures.”

By 1998, the district court had dismissed the claims based upon fraud and unfair competition, and had found the C&F patent to be invalid. After a trial, the court awarded damages to C&F on its remaining claim, for trade secret misappropriation. In settlement, IBP paid $11 million to C&F and Pizza Hut paid $15.3 million. The settlement agreement with Pizza Hut referred to the “payment of a lump sum payment in full and complete discharge and settlement of the lawsuit,” and contained mutual releases.

C&F was an S corporation, that is, one in which company income is passed through to shareholders, who must report it on their individual tax returns. C&F’s tax returns reported the settlement funds as capital gains realized upon the sale of trade secrets. Relying on K-1s that C&F provided them, the shareholders likewise reported the amounts as long-term capital gains on their personal tax returns.

The IRS disputed this characterization, asserting that these amounts constituted ordinary income. The taxpayers responded that the settlement was paid for damage to the C&F trade secrets, or, in the alternative, for the sale of the trade secrets to Pizza Hut. The parties litigated the matter before the United States Tax Court.

The Tax Court began its analysis of these facts by reciting the truism, stated in an earlier ruling, that “the taxability of the proceeds of a lawsuit depends upon the nature of the claim and the actual basis of recovery. . .Where the recovery represents damages for lost profits or other items taxed as ordinary income, it is taxable as ordinary income. Where the recovery represents damages for injury to, or destruction of, a capital asset, it is taxable as capital gain to the extent it exceeds the taxpayer’s basis in the asset.”

Notably, the IRS did not dispute that the C&F trade secret was a capital asset, or that compensation for damage to a capital asset could result in capital gain. The debate centered on the question of whether the payments received were to compensate C&F for damage to its trade secrets, or whether they were to compensate C&F for lost income.

In deciding the matter, the Tax Court looked to the pleadings and the settlement agreement. The allegation in C&F’s complaint that Pizza Hut had caused it “lost profits, lost opportunities, operating losses and expenditures” was fatal to the argument in favor of capital gains treatment.

The Tax Court dispensed with the alternative argument, that the money was in payment for the sale of the trade secrets, by noting that C&F had not transferred to Pizza Hut “all substantial rights” to the trade secrets because it retained the right to use them. In fact, the Tax Court held that C&F had not actually transferred any right in the trade secrets because Pizza Hut was not entitled to sue third parties for misappropriation of those secrets.

The Tax Court held in favor of the IRS, and the shareholders were required to pay substantially more tax.

What lessons can be learned from this story?

First, it is not wise to rely on oral promises. While C&F eventually was made whole, it would have enjoyed a much smoother process had it refrained from disclosing its trade secrets until it had a long-term, written purchase commitment from Pizza Hut.

Second, even if a patent is found to be invalid, trade secret rights, if properly preserved through non-disclosure agreements, can be very substantial.

Third, favorable tax treatment may depend upon the wording chosen in framing a complaint and/or settlement agreement. There are times when it is hard to clearly discern whether monies being paid are truly capital or ordinary in nature. For that reason, it is smart to plan for the end-game at the very beginning.

The complaint should at the least contain an alternative theory based upon injury to a capital asset such as a patent, a copyright, a trade name or a trade secret. Ideally, that theory will be pursued throughout the litigation and highlighted in the settlement agreement.

In such a case, the IRS might refrain from challenging an assertion that the amounts paid on the judgment or in settlement represent a capital gain; or the Tax Court may be more sympathetic to such a plantiff than it was to C&F, for whom tax considerations were apparently an afterthought.

Needless to say, this article is not tax advice that you can rely upon. It is however food for thought.