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 millionEthex 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:
Damage to Goodwill and Reputation: $10.45 million
Lost Profits: $1.35 million
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.