Florida Tax Attorney Blog

In Healthpoint, Ltd. v. Commissioner, T.C. Memo 2011-24, the U.S. Tax Court addressed the frequently considered question of whether amounts received in settlement of litigation should be taxed as capital gain or ordinary income. The conclusion: it depends. This is because the character of the income for tax purposes is determined by the nature of the settlement award itself. Stated more simply, tax character depends on what the recipient of the award is being compensated for. For instance, punitive damages would be taxed as ordinary income. On the other hand, reputation damages would be taxed as capital gain. In the past, this has generally meant that settlement agreements determined tax consequences. That is, the parties to the settlement would include an allocation of the settlement award among various types of damages within the settlement agreement itself, and that allocation would determine the income tax consequences to the recipient. Significantly, however, the IRS successfully challenged the parties' allocation in Healthpoint.

Facts. Healthpoint Ltd. ("Healthpoint"), a specialty pharmaceutical company, owned the exclusive rights to a popular prescription cream used in the treatment of wounds. Ethex Corporation ("Ethex"), another pharmaceutical company, developed a competing cream which it marketed as comparable to Healthpoint's popular ointment. In reality, Ethex's cream was not comparable to Healthpoint's cream at all. To the contrary, it was formulated with different ingredients, and many users experienced side effects and otherwise adverse results.

Because Ethex marketed its cream as comparable to Healthpoint's cream, doctors and other healthcare practitioners stopped prescribing both creams as a result of the negative patient experiences with the Ethex cream. As a result, Healthpoint experienced lower-than-projected sales and brought suit against Ethex for its lost profits. Specifically, the lawsuit alleged false advertising, unfair competition, misappropriation, and trademark dilution. In the meantime, Ethex formulated an improved version of its cream and brought it to market while Healthpoint's lawsuit against it was pending. Healthpoint responded with a second lawsuit, raising the same allegations as in the first suit, plus trademark theft.

The first lawsuit ultimately awarded Healthpoint $16.5 million in damages, allocated as follows:

Actual Damges: $5 million

Lost Profits: $1.64 million

Punitive Damages: $3.2 million

Trademark Dilution: $6.3 million

Ethex appealed, and the parties entered into settlement negotiations while the appeal was pending. Ultimately, the parties agreed to settle both lawsuits for $15.8 million, allocated as follows:

Lawsuit #1:

Damage to Goodwill and Reputation: $10.45 million

Lost Profits: $1.35 million

Lawsuit #2:

Damage to Goodwill and Reputation: $4.05 million

Lost Profits: $450,000

As a result, Healthpoint reported $1.8 million of ordinary income and $14.5 million of capital gain. This character differential could have been inconsequential if Healthpoint were a corporation without substantial capital losses (because corporations are not entitled to the preferential capital gains rates). However, because Healthpoint was structured as a partnership, all tax attributes passed through to the individual partner level. Thus, there were substantial tax savings to be had here by characterizing the bulk of the settlement award as capital gain. Not surprisingly, the IRS challenged Healthpoint's characterization, and the issue was litigated before the Tax Court.

Holding. In the end, the Tax Court reallocated the settlement award in a way that reflected what it perceived to be the economic realities of the underlying claims. This included a partial allocation for punitive damages, which are taxable as ordinary income, despite explicit language in the settlement agreement stating that no portion of the settlement amount constituted a punitive damage award.

Practical Implications. Settlement agreements will be afforded less weight in determining tax consequences going forward. As a result, taxpayers must be able to substantiate any allocation of the settlement proceeds that the settlement agreement purports to make. In other words, it is no longer sufficient to simply set forth an allocation of damages in the settlement agreement.

How to avoid the Healthpoint result. In recharacterizing the allocation of the settlement award, the Tax Court emphasized that Healthpoint failed to provide any documentation to support or otherwise justify its allocations. Additionally, the Court pointed out that Healthpoint was cognizant of the tax consequences of its allocation. With that being said, I would urge taxpayers in settlement negotiations to do two things: (1) create a paper trail to support the allocation of the settlement award; and (2) deemphasize any tax motivation for certain allocations during settlement negotiations.

There are two certainties in life: death and taxes. This is especially true in the viatical settlement context. A viatical settlement involves the sale of a life insurance policy by the insured during his or her lifetime. In effect, the investor will finance the insured's life insurance policy in exchange for being named beneficiary of the policy. In this way, the insured is able to extract value from the policy during his or her lifetime. When the insured dies, the investor is entitled to receive death benefits under the policy.

Although I.R.C. § 101(a) generally excludes life insurance proceeds from gross income, life insurance proceeds are includible in gross income in cases where, as in the viatical settlement context, the underlying policy was "transferred for valuable consideration." I.R.C. § 101(a)(2). In that case, the transferee of the policy must recognize income to the extent the death benefits exceed its basis in the policy. Therefore, a viatical settlement investor has income to the extent of his or her basis, which in most cases will be the cost of the investment. See generally, I.R.C. § 1001.

But when must this income be recognized for tax purposes? When the insured dies and the investor becomes entitled to the life insurance proceeds? Or when the investor actually receives payment from the insurance company? In many cases, the insured dies and the investor receives payment in the same year. But what about the case where the insured dies in one year and the investor does not receive payment from the insurance company until the following year?

Under I.R.C. § 451(a), income is included in a taxpayer's gross income in the taxable year in which it is received, unless properly accounted for in a different period. This means that cash basis investors may defer recognition of income until the year of receipt. However, under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income, and the amount thereof can be determined with reasonable accuracy. Treas. Reg. § 1.451-1(a).

Fixed Right to Income. Where a right to receive income is subject to one or more conditions precedent or other contingencies, courts have generally held that accrual of income is not required. E.g., Ringmaster, Inc. v. Commissioner, T.C. Memo. 1962-167 (accrual not required prior to purchaser's acceptance of sale conditions); Webb Press Co. Ltd. v. Commissioner, 3 B.T.A. 247 (1925) (accrual not required until acceptance after testing product). In these types of cases, the complexity of the tax laws and the potential for different interpretations of relevant statutes justifies non-accrual.

However, a "ministerial" contingency will not delay establishment of the fact of liability. Dally v. Commissioner, 227 F.2d 724 (9th Cir. 1955). In this regard, requirements of invoice certification, claim submission, and claim processing have been held to be ministerial acts which do not cause the right to income to be unfixed. Dally v. Commissioner, 227 F.2d 794 (9th Cir. 1955) (invoice certification); Rev. Rul. 98-39, 1998-2 C.B. 198 (claim submission); U.S. v. General Dynamics Corp., 481 U.S. 239 (1987) (claim processing). Therefore, the viatical settlement investor's right to receive income becomes fixed on the date of the insured's death. At that point, all conditions precedent to the investor's right to income have been satisfied. (Of course, this assumes that the insurer does not contest its obligation or otherwise have discretion to deny the claim).

Determinable with Reasonable Accuracy. Under the all events test, income must be reported in the tax year in which its collectability is assured, not in the year in which it is actually received. Clifton Manufacturing Co. v. Commissioner, 137 F.2d 290 (U.S. Tax Court 1943). However, if a taxpayer has "good reason" to believe that income cannot be collected, accrual is not required. American Fork & Hoe Co.v. Enterprise Manufacturing Co., 64 F.2d 1008 (1933).

The U.S. Tax Court has found "good reason" where there is "serious doubt as to ultimate collection." Corn Exchange Bank v. U.S., 37 F.2d 34 (U.S. Tax Court 1930). As for what constitutes "serious doubt," the law is unclear. But the law is relatively clear as to what does not constitute "serious doubt." Indeed, the Tax Court has explicitly stated that, "the fact that a lapse of time is contemplated before collection . . . does not constitute doubtful collectability." Harmont Plaza, Inc. v. Commissioner, 64 TC 632 (U.S. Tax Court 1977). Consequently, the fact that an accrual-basis investor may not receive payment of the death benefits in the year of death does not justify non-accrual. The income must be reported in the year of death, notwithstanding whether income is actually received in that year.

Buyer and Seller enter into a purchase and sale contract pursuant to which buyer places a deposit. Buyer breaches contract. Seller retains deposit. It happens more than you would think. And an interesting tax question is presented when it does: does the retained deposit constitute taxable income to the seller? And if so, is that income taxed as ordinary income rates? Or can the seller take advantage of the preferential capital gains rates?

As an initial matter, it should be noted that a "sale or other disposition of property" is a necessary precondition to a capital gain. See I.R.C. 1001(a). Obviously, there is no sale where a seller retains a deposit as a consequence of a contractual breach on the buyer's part. But is there a "disposition" within the meaning of I.R.C. 1001?

At the outset, the answer would appear to be an obvious no insofar as the seller continues to hold title to the property. After all, isn't disposal of the asset an essential component of an asset disposition?

One would think so. However, the U.S. Tax Court has analogized earnest money deposits to option payments. See e.g., Ahadpour v. Commissioner, TC Memo 1999-9. This is significant because there is language in the Internal Revenue Code which treats gain realized on the lapse of an option as capital gain.

Specifically, I.R.C. 1234(b)(1) provides:

In the case of the grantor of the option . . . gain on lapse of an option in property shall be treated as a gain . . . from the sale or exchange of a capital asset held not more than one year."

To be sure, "property" is narrowly defined for purposes of Section 1234 to include only stock, securities, commodities, and commodity futures. IRC § 1234(b)(2)(B). However, the Taxpayer Relief Act of 1997 extended sale or exchange treatment to "any property . . . [that] is a capital asset in the hands of the taxpayer." I.R.C. 1234A (emphasis added). In this regard, the legislative history of I.R.C. 1234A explicitly lists forfeiture of a down payment under a contract as an example of the type of property to which Section 1234A applies. See Staff of the Joint Comm. on Tax'n, General Explanation of Tax Legislation Enacted in 1997, 105th Cong., 1st Sess. 189.

But Section 1234(b)(1) treats a gain on lapse of an option as a short-term capital gain, and the preferential capital gains tax rates are only available for long-term capital gains. See I.R.C. 1234(b)(1) ("[G]ain on lapse of an option in property shall be treated as a gain . . . from the sale or exchange of a capital asset held not more than one year") (emphasis added); see generally I.R.C. 1(h).

Significantly, however, Section 1234A provides for treatment as "gain or loss from the sale of a capital asset." This is in contrast to Section 1234(b), which provides for treatment as "gain . . . from the sale or exchange of a capital asset held not more than one year." (emphasis added). Presumably, if Congress had intended to provide for short-term capital loss treatment in Section 1234A, it could have easily done so by including language similar to that which is found in 1234(b).

With that being said, the plain language of I.R.C. 1234A arguably supports long-term capital gain treatment of the retained deposit. (Of course, the counter-argument would be that I.R.C. 1234A was intended to extend I.R.C. 1234(b)'s sale or exchange treatment to a broader class of property, and as such, it should be construed consistently with that provision).

In any event, it should be emphasized that in Ahadpour (cited above for treatment of earnest money deposit as option to purchase), the Tax Court treated the forfeited deposit as ordinary income. Although this decision was issued in 1999, after the 1976 addition of 1234(b) and the 1997 addition of 1234A, the Court relied on pre-1234A case law in reaching that result. Thus, it is questionable whether this case was correctly reasoned.