111 T.C. No. 13
UNITED STATES TAX COURT
BRIAN L. AND CAROLE J. NAHEY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8497-96. Filed October 21, 1998.
W, a corporation, sued X for breach of contract and misrepresentation for failing to complete the installation of a computer system and sought damages for lost profits. X counterclaimed for withheld payments by W.
In 1986, P, through his two S corporations, acquired all of the assets and assumed all of the liabilities of W, including W's lawsuit against X and X's counterclaim against W. W was thereafter liquidated. No part of the purchase price for W's assets was allocated to the claim against X.
In 1992, the lawsuit with X was settled for total consideration of $6,345,183. The settlement proceeds were paid to the S corporations and reported as long-term capital gain that passed through to P. R determined that the settlement proceeds constituted ordinary income. P asserts that the lawsuit constituted a capital asset and - 2 -
that the settlement of the lawsuit constituted a sale or exchange for purposes of the capital gain provisions. Held: The settlement of the lawsuit between the S corporations and X did not constitute a sale or exchange pursuant to sec. 1222, I.R.C., and thus the settlement proceeds received by the S corporations and passed through to P constitute ordinary income.
Robert A. Schnur and Joseph A. Pickart, for petitioners.
George W. Bezold and Christa A. Gruber, for respondent.
JACOBS, Judge: Respondent determined a $185,833 deficiency in
petitioners' 1992 Federal income taxes.
The deficiency herein arises from the parties' dispute over
the characterization of settlement proceeds from a lawsuit that was
brought by a corporation whose assets, including the lawsuit, were
purchased by petitioners' two S corporations. The sole issue we
must decide is whether the settlement proceeds received by the S
corporations (and passed through to petitioners) constitute
ordinary income, as respondent contends, or long-term capital gain,
as petitioners contend.1
All section references are to the Internal Revenue Code as in
effect for the year in issue.
1 In their petition contesting respondent's determination that the settlement proceeds received by the S corporations (and passed through to petitioners) constitute ordinary income, petitioners asserted, as an alternative position, that the S corporations should have reported the settlement proceeds as a nontaxable return of capital. In their posttrial brief, petitioners abandoned this alternative argument. - 3 -
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The
stipulated facts are incorporated in our findings by this
reference.
At the time the petition was filed, petitioners Brian L. and
Carole J. Nahey, husband and wife, resided in Hartland, Wisconsin.
(All references to petitioner in the singular are to Mr. Nahey.)
Wehr Corporation
Wehr Corporation (Wehr), a Wisconsin corporation, manufactured
and distributed a variety of industrial equipment and devices, such
as air distribution equipment, high-technology electronics, motor
brakes, clutches, and refractory brick presses.
From the mid-1970's until the end of 1986, petitioner held the
positions of president, chief executive officer, and member of the
board of directors of Wehr.
At the end of 1986, petitioner owned approximately 10 percent
of the stock of Wehr, Bruce A. Beda (who is not described in the
record) owned an additional 3 percent, and the balance of the stock
was owned by members of the Manegold family directly or through
trusts established for their benefit.
The Xerox Lawsuit
On December 31, 1983, Wehr contracted with Xerox Corporation
(Xerox) to implement and install a fully integrated on-line, closed
loop computer system to unite all of Wehr's operational, - 4 -
managerial, and administrative functions in a real-time manner.
Upon installation, this system would have given Wehr a competitive
edge in its marketplace, increasing its revenues and profits.
Pursuant to the terms of the contract, which were negotiated
by petitioner on behalf of Wehr, Xerox agreed to complete the
project by December 31, 1984. During the period in which Xerox was
to implement and install the new system, Xerox allowed Wehr to run
its (Wehr's) information services systems on Xerox's computers in
California on a fee-for-service basis of approximately $70,000 per
month.
From the inception of the project, Xerox fell behind schedule
and missed target dates. Wehr responded to Xerox's missed target
dates by withholding payment of the monthly fee for using Xerox's
computer services in California. In January 1985, at which time
Wehr estimated that only 1 to 2 percent of the required services
had been performed, Xerox warned Wehr that its continued failure to
pay would result in the termination of all services. Nonetheless,
Wehr still refused to pay, and Xerox terminated all services. At
that time, Wehr allegedly owed $652,984.33 to Xerox.
On February 11, 1985, Wehr filed a lawsuit against Xerox in
the United States District Court for the Eastern District of
Wisconsin, alleging breach of contract, intentional fraud and
misrepresentation, and negligent misrepresentation. Although no
specific amount of damages was stated, the complaint alleged that - 5 -
such damages exceeded $5 million. In its answer to the lawsuit,
Xerox asserted a counterclaim that Wehr wrongfully withheld
payments to Xerox and demanded damages in the amount not yet paid.
Sometime in 1986 while discovery proceeded, a newly appointed
Xerox division president visited petitioner in Milwaukee and
proposed to settle Wehr's claim for $1.2 million, although he
indicated he could go as high as $2 million. This offer was
rejected by petitioner.
Throughout the course of the litigation, petitioner, in his
capacity as chief executive officer at Wehr, kept the board of
directors and Mr. Manegold (who was chairman of the board) informed
about the lawsuit as well as the proposed settlement and its
rejection. Petitioner also informed Mr. Manegold that he believed
Wehr could recover as much as $10 million from Xerox.
Petitioner's Acquisition of Wehr
During the fall of 1986, Mr. Manegold contacted petitioner and
inquired whether he was interested in purchasing Wehr's assets.
(Apparently, Mr. Manegold anticipated forthcoming changes in the
tax laws that made it advantageous for him and his family to sell
Wehr prior to the end of 1986.) Mr. Manegold's asking price was in
excess of $100 million, which required petitioner to seek
financing.
Petitioner spoke with investment banks about assisting in the
purchase of Wehr. The investment banks offered to finance the - 6 -
acquisition in exchange for control of Wehr--which petitioner
opposed. Throughout the discussions with the investment banks,
petitioner informed the bankers of the pending lawsuit because of
its impact on cash-flows; the lawsuit also appeared in Wehr's
financial reports. Petitioner believed Wehr would receive between
$2 million and $10 million from the lawsuit against Xerox.
Ultimately, petitioner proposed that Mr. Manegold finance the
deal as part of a leveraged buy out (in which petitioner would
pledge his shares and use the cash-flows from the corporation to
repay the debt and interest). In evaluating the financing
possibilities, petitioner analyzed Wehr's cash-flow potential, and
included the lawsuit against Xerox in that analysis. Mr. Manegold
based the $100 million asking price on a multiple of earnings
analysis.
On December 30, 1986, petitioner and Mr. Manegold reached an
agreement for the acquisition of Wehr. Petitioner organized two S
corporations (hereinafter referred together as the S corporations),
Venturedyne, Ltd. (Venturedyne), and Carnes Company, Inc. (Carnes),
for the purpose of acquiring Wehr. Pursuant to the acquisition
agreement, Venturedyne purchased all the assets and assumed all the
liabilities of Wehr, other than those related to the Carnes
division of Wehr. All the assets and liabilities of the Carnes
division of Wehr were acquired and assumed by Carnes. Through
1992, petitioner owned 97.624190 percent of each of the S - 7 -
corporations, and the remainder was owned by Mr. Beda. Since the
inception of Venturedyne and Carnes, petitioner has served as the
chairman of the board of directors, president, and chief executive
officer of both entities.
Following the purchase of Wehr's assets and the assumption of
Wehr's liabilities by the S corporations, Wehr was liquidated. The
S corporations continued to operate the same businesses as operated
by Wehr prior to its liquidation.
Among the assets acquired by the S corporations were all
lawsuits brought by Wehr, including the claim against Xerox. The
liabilities assumed by the S corporations included all lawsuits
brought against Wehr, including Xerox's counterclaim. Because the
parties to the buy out of Wehr did not allocate the purchase price
to specific assets, the S corporations engaged two accounting firms
to assist in that process. The accounting firms attempted to
determine a value for the Xerox lawsuit, but no value was assigned
to Wehr's claim against Xerox because the accountants determined
that the value of such claim was "too speculative". Thus, no
portion of the purchase price for Wehr's assets was allocated to
the Xerox lawsuit, and neither of the S corporations booked the
lawsuit as an asset. (However, a footnote in the S corporations'
audited financial statements identified the existence of the claim
against Xerox.) In a Closing Agreement On Final Determination
Covering Specific Matters between the S corporations, petitioners, - 8 -
Mr. Beda, and the Commissioner, executed on July 1, 1993, no
portion of the purchase price was allocated to the Xerox lawsuit.
The Xerox Lawsuit: Post-1986
Following the buy out of Wehr, the S corporations continued
the lawsuit against Xerox in Wehr's name. The primary disagreement
of the parties to that lawsuit during the post-1986 period
concerned the nature and extent of the damages caused by Xerox's
failure to complete the implementation and installation of the
computer system. The parties fought over: (1) Whether Xerox could
examine the S corporations' audited financial statements with
respect to the issue of lost profits (even though the damages were
alleged only with respect to Wehr); (2) whether Wehr could continue
to pursue noncontract claims under the so-called economic loss
doctrine; (3) whether Wehr had a duty to mitigate damages following
the termination of services by Xerox, and if so, when would the
computer system project have been completed if it had been
continued by Xerox or another party; and (4) whether Wehr could
introduce a new method of calculating damages that produced figures
ranging from $20 million to more than $120 million in damages.
In late 1992, the District Court ruled that Wehr could
introduce evidence as to the new method of calculating damages at
trial; immediately thereafter, Xerox sought to settle the lawsuit.
Initially, Xerox offered between $2 million and $3 million, but
petitioner responded that he would not accept less than $10 - 9 -
million. Xerox indicated that it would go no higher than $6
million, and petitioner's counsel, who believed that Xerox's
mitigation argument was a strong one, advised petitioner to accept
that amount. The parties eventually agreed to a settlement by
which Xerox would pay $5,950,000 in cash and cancel the $395,183
debt owed by Wehr (and assumed by the S corporations) to Xerox, for
a total of $6,345,183. The lawsuit was then dismissed with
prejudice. The cash payment was made by Xerox on or before
December 31, 1992.
Reporting of the Settlement
The S corporations allocated the settlement with Xerox as
follows: $3,502,541 to Venturedyne; $2,842,183 to Carnes. The S
corporations each reported the settlement as long-term capital gain
on their respective 1992 corporate income tax returns. Petitioners
similarly reported their allocable share of the settlement
($6,194,437) as long-term capital gain on their 1992 joint income
tax return. In calculating the capital gain, neither the S
corporations nor petitioners attributed any basis to the lawsuit.
In the notice of deficiency, respondent determined that the
settlement proceeds should have been reported as ordinary income.
OPINION
The sole issue for decision herein is whether the proceeds
received by the S corporations from the settlement of Wehr's
lawsuit against Xerox (the settlement proceeds) should be - 10 -
characterized as ordinary income or long-term capital gain. The
resolution of this issue turns on whether the requirements for
obtaining capital gain treatment are satisfied, including whether
the settlement of Wehr's lawsuit against Xerox constitutes a "sale
or exchange".
The parties center their arguments on the "origin of the
claim" test to determine whether the settlement proceeds should be
characterized as capital gain or ordinary income. See United
States v. Hilton Hotels Corp., 397 U.S. 580 (1970); Woodward v.
Commissioner, 397 U.S. 572 (1970); United States v. Gilmore, 372
U.S. 39 (1963); Gidwitz Family Trust v. Commissioner, 61 T.C. 664,
673 (1974); Keller Street Dev. Co. v. Commissioner, T.C. Memo.
1978-350, affd. 688 F.2d 675 (9th Cir. 1982). We, however, shall
focus our attention on whether the settlement of the lawsuit
constitutes a sale or exchange.
A sale or exchange is a prerequisite to the rendering of
capital gain treatment. Sec. 1222; Estate of Nordquist v.
Commissioner, 481 F.2d 1058, 1061 (8th Cir. 1973), affg. T.C. Memo.
1972-198; Ackerman v. United States, 335 F.2d 521, 526-527 (5th
Cir. 1964); Breen v. Commissioner, 328 F.2d 58, 64 (8th Cir. 1964),
affg. T.C. Memo. 1962-230. The phrase "sale or exchange" is not
defined in section 1222, but we apply the ordinary meaning to those
words. Helvering v. William Flaccus Oak Leather Co., 313 U.S. 247,
249 (1941). - 11 -
It is well established that a compromise or collection of a
debt is not considered a sale or exchange of property because no
property or property rights passes to the debtor other than the
discharge of the obligation. See Fairbanks v. United States, 306
U.S. 436 (1939); National-Standard Co. v. Commissioner, 749 F.2d
369 (6th Cir. 1984), affg. 80 T.C. 551 (1983); Osenbach v.
Commissioner, 198 F.2d 235 (4th Cir. 1952), affg. 17 T.C. 797
(1951); Lee v. Commissioner, 119 F.2d 946 (7th Cir. 1941), affg. 42
B.T.A. 920 (1940); Guthrie v. Commissioner, 42 B.T.A. 696 (1940);
Hale v. Commissioner, 32 B.T.A. 356 (1935), affd. sub nom. Hale v.
Helvering, 85 F.2d 819 (D.C. Cir. 1936). In this regard, whatever
property or property rights might have existed vanish as a result
of the compromise or collection. Leh v. Commissioner, 27 T.C. 892,
898 (1957), affd. 260 F.2d 489 (9th Cir. 1958).
On several occasions we have addressed the issue of whether a
sale or exchange occurred on the payment of a judgment or the
settlement of a claim. See Towers v. Commissioner, 24 T.C. 199
(1955), affd. 247 F.2d 233 (2d Cir. 1957); Hudson v. Commissioner,
20 T.C. 734 (1953), affd. per curiam sub nom. Ogilvie v.
Commissioner, 216 F.2d 748 (6th Cir. 1954); Fahey v. Commissioner,
16 T.C. 105 (1951). In Fahey v. Commissioner, supra, we held that
where an attorney was assigned an interest in a contingent lawsuit
fee in exchange for a cash payment, settlement of the lawsuit and
payment of the fee to the attorney did not give rise to capital - 12 -
gain treatment because no sale or exchange occurred. In reaching
our conclusion, we quoted from the opinion of the Court of Appeals
for the District of Columbia in Hale v. Helvering, supra (relating
to the compromise of a note for less than face value):
There was no acquisition of property by the debtor, no transfer of property to him. Neither business men nor lawyers call the compromise of a note a sale to the maker. In point of law and in legal parlance property in the notes as capital assets was extinguished, not sold. In business parlance the transaction was a settlement and the notes were turned over to the maker, not sold to him. * * *
Fahey v. Commissioner, supra at 109.2
In Hudson v. Commissioner, supra, the taxpayers purchased a
50-percent interest in a judgment from the legatees of an estate,
and subsequently the taxpayers settled the judgment with the
debtor. The taxpayers reported the payment of the judgment as
capital gain. We held that the payment should be characterized as
ordinary income, explaining:
We cannot see how there was a transfer of property, or how the judgment debtor acquired property as the result of the transaction wherein the judgment was settled. The most that can be said is that the judgment debtor paid a debt or extinguished a claim so as to preclude the execution on the judgment outstanding
2 Our reasoning in Fahey v. Commissioner, 16 T.C. 105 (1951), was followed by the Court of Appeals for the Fifth Circuit in Pounds v. United States, 372 F.2d 342, 349 (5th Cir. 1967), a case relied on by petitioners in support of their argument that the Xerox lawsuit was a capital asset. The Pounds court found that no sale or exchange occurred on the payment of a 12-1/2 percent profit interest in a land deal because following the transaction only one party, the taxpayer, received property (the cash payment). - 13 -
against him. In a hypothetical case, if the judgment had been transferred to someone other than the judgment debtor, the property transferred would still be in existence after the transaction was completed. However, as it actually happened, when the judgment debtor settled the judgment, the claim arising from the judgment was extinguished without the transfer of any property or property right to the judgment debtor. In their day-to- day transactions, neither businessmen nor lawyers would call the settlement of a judgment a sale; we can see no reason to apply a strained interpretation to the transaction before us. When petitioners received the $21,150 in full settlement of the judgment, they did not recover the money as a result of any sale or exchange but only as a collection or settlement of the judgment.
Id. at 736.
Despite these and other similar cases3, petitioners contend
that the passing of property or property rights to the debtor is
not relevant in determining whether a sale or exchange occurred.
In support of this argument, petitioners direct us to Commissioner
v. Ferrer, 304 F.2d 125 (2d Cir. 1962), revg. in part and remanding
35 T.C. 617 (1961). In Ferrer, the taxpayer acquired from an
author the right to produce a play (based on the author's book)
which included the right to prevent the author's transfer of film
rights. Subsequently, the taxpayer surrendered his rights (the
"lease") in exchange for the leading role in a film production.
The issue arose as to whether the surrendering of the taxpayer's
3 The Court of Appeals for the Seventh Circuit, the court to which an appeal in this case lies, has distinguished sales or exchanges from collections and other transactions in which no property or property rights survive. See Chamberlin v. Commissioner, 286 F.2d 850, 852 (7th Cir. 1960), affg. 32 T.C. 1098 (1959); Lee v. Commissioner, 119 F.2d 946, 948 (7th Cir. 1941), affg. 42 B.T.A. 920 (1940). - 14 -
rights constituted a sale or exchange for purposes of the capital
gain provisions. In holding that a sale or exchange of the
surrendered lease occurred, the Court of Appeals for the Second
Circuit stated that Congress was disenchanted with the "formalistic
distinction" between a sale of property rights to third parties
(which would give rise to capital gain or loss) and the release of
those rights that results in their extinguishment (and which would
not give rise to capital gain or loss). The court continued:
In the instant case we can see no sensible business basis for drawing a line between a release of Ferrer's rights * * * and a sale of them * * *. * * * Tax law is concerned with the substance, here the voluntary passing of "property" rights allegedly constituting "capital assets," not with whether they are passed to a stranger or to a person already having a larger "estate." * * *
Id. at 131.
Petitioners have misread Ferrer and its import. Ferrer (and
the cases cited therein) can be factually distinguished from the
instant case because in Ferrer the taxpayer's interest (or lease)
to produce the play and prevent the author's transfer of film
rights did not disappear but instead reverted to the author after
the taxpayer surrendered the lease; whereas in the instant case,
the S corporations' rights in the lawsuit vanished both in form and
substance upon the receipt of the settlement proceeds.
In the case herein, the S corporations and Xerox settled the
lawsuit originally brought by Wehr. The S corporations received
consideration of $6,345,183; Xerox received nothing other than the - 15 -
discharge of the liability that arose as the result of the lawsuit.
We find no discernible distinction between the situation herein and
the situations discussed in Fahey v. Commissioner, supra, or Hudson
v. Commissioner, supra. In each case, the debtor made payment to
the creditor or an assignee of the original creditor in exchange
for the extinguishment of the claim. Whether the claim is reduced
to judgment before payment is not relevant; ultimately the debtor
receives nothing in the form of property or property rights which
can later be transferred. Consequently, we hold that the
settlement of the lawsuit between the S corporations and Xerox does
not constitute a sale or exchange and hence capital gain treatment
is not warranted.
Petitioners argue that the so-called Arrowsmith doctrine
requires us to apply capital gain treatment to the settlement claim
regardless of whether a sale or exchange occurred. We disagree.
In Arrowsmith v. Commissioner, 344 U.S. 6 (1952), the Supreme Court
held that the characterization of a transaction may require
examination of prior, related transactions. In Arrowsmith, the
taxpayer-shareholders reported as capital gain the gain realized on
the liquidation of their corporation. Subsequently, a judgment was
rendered against the former corporation, and the shareholders, as
transferees of the corporation's assets, paid the judgment. The
Supreme Court held that the payment of the judgment resulted in a
capital (rather than ordinary) loss because the judgment was - 16 -
inextricably related to the capital gain which resulted from the
liquidation.
Here, petitioners assert that the receipt of the settlement
proceeds is related to a prior transaction, namely the acquisition
of Wehr's assets, citing Bresler v. Commissioner, 65 T.C. 182
(1975). In Bresler, the shareholder of an S corporation sought to
treat the proceeds from the settlement of an antitrust lawsuit as
capital gain, asserting that the settlement was intended to
compensate the taxpayer for losses that resulted from the earlier
sale of certain properties. We rejected that argument because the
earlier sale of the properties resulted in ordinary losses under
section 1231, and thus under Arrowsmith v. Commissioner, supra, the
settlement proceeds constituted ordinary income.
Petitioners have misapplied the rationale of Arrowsmith and
its progeny, including Bresler, to the situation herein. The
acquisition of Wehr's assets was not the basis for the lawsuit
against Xerox, and the settlement in favor of the S corporations
was not related to the leveraged buy out. Cf. West v.
Commissioner, 37 T.C. 684, 687 (1962). The origin of the claim in
this case was Xerox's breach of contract, as detailed in the
complaint filed by Wehr in the District Court. The treatment of
the settlement proceeds as ordinary income or capital gain is not
dependent on the fact that the S corporations acquired Wehr's - 17 -
assets in a capital transaction.4 As such, the Arrowsmith doctrine
is inapplicable.
We have considered all of petitioners' other arguments and
find them to be not relevant or without merit.
In conclusion, we hold that the settlement of the Xerox
lawsuit did not constitute a sale or exchange; consequently, the
settlement proceeds constitute ordinary income, not capital gain,
to petitioners. Inasmuch as petitioners allocated no part of the
purchase price for Wehr's assets to the Xerox lawsuit, they
acquired no basis in the lawsuit. Thus, the entire settlement
proceeds are includable in gross income.
To reflect the foregoing,
Decision will be entered
for respondent.
4 As stated in Fahey v. Commissioner, 16 T.C. at 108, and reiterated in Pounds v. United States, 372 F.2d at 349, the mere occurrence of a sale or exchange of the subject asset at some point in time is not sufficient to obtain capital gain treatment on a later disposition. The sale or exchange must be proximate to the event which gave rise to the gain.