On May 13, 2020, the Tax Court issued a Memorandum Opinion in the case of NCA Argyle LP v. Commissioner (T.C. Memo. 2020-56). The basic issue before the court in NCA Argyle LP v. Commissioner was whether proceeds received from the settlement of a lawsuit involving punitive damages which proceeds were received in exchange for the plaintiff/taxpayer’s interests in joint ventures (a capital asset) were properly treated as gain on the sale of a capital asset.
Background to NCA Argyle LP v. Commissioner
Of the 25-page opinion, over 12 pages are dedicated to the factual background of the case. As the reproduction of the facts below is only a paragraph long, it glosses over a few details along the way.
The petitioner, NCA, entered into real estate joint ventures with Commonfund. When Commonfund later disavowed those joint ventures, the two parties ended up in litigation. NCA was awarded damages for the value of the joint venture interests repudiated by Commonfund, plus punitive damages. Ultimately, during the appeal of the case, the parties settled for a lump-sum payment from Commonfund to NCA in exchange for NCA’s relinquishing whatever rights it had in the joint ventures.
The IRS argued that most of this payment was ordinary income because the payment represented estimates of future income. The IRS further argued that a portion of the payment is ordinary income attributable to the receipt of punitive damages. NCA disagreed, and here we are.
Treatment of Future Profits or Partnership Interest
The IRS and NCA dispute how to characterize the $23 million received by NCA. NCA argues that the entire $23 million was in exchange for its joint venture interests. The IRS argues that $5 million was received for the lost joint venture interests and the remaining $18 million was received as compensation for lost fees and punitive damages.
The sale or exchange of a partnership interest is generally treated as the sale or exchange of a capital asset. IRC § 741. Any amounts received as compensation for lost profits, however, must be treated as ordinary income. See Estate of Longino v. Commissioner, 32 T.C. 904, 905 (1959). Amounts received as punitive damages are taxable as ordinary income to the recipient. See Greene v. Commissioner, T.C. Memo. 1983-653 (citing Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 432 (1955)).
Easy enough, right? Not so fast, Skippy.
Tax Treatment of Settlement Proceeds
The tax treatment of proceeds received in settlement of a claim is generally guided by the nature or “origin” of the claim. See United States v. Burke, 504 U.S. 229, 237 (1992). In other words, the Tax Court looks to the parties’ characterization of the claim for which the settlement was paid. See Bagley v. Commissioner, 105 T.C. 396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997).
The nature of the “underlying claim” is a factual determination, which the Tax Court makes by considering all factors and circumstances involving the claim, giving the greatest weight to the terms of the settlement agreement. See Robinson v. Commissioner, 102 T.C. 116, 126 (1994), aff’d in part, rev’d in part, 70 F.3d 34 (5th Cir. 1995); McKay v. Commissioner, 102 T.C. 465, 482 (1994), vacated on other grounds, 84 F.3d 433 (5th Cir. 1996). If the settlement agreement expressly allocates the settlement proceeds to a type of damages, the Tax Court will generally (read: practically always) follow that allocation if the agreement was reached by adversarial parties in arm’s-length negotiations and in good faith. See Bagley, 105 T.C. at 406.
In McKay, 102 T.C. at 482, the Tax Court observed that the express language in a settlement agreement is the most important factor in determining why the settlement payment was made. In the present case, the allocation is clear. NCA relinquished its rights, titles, and interests in the joint ventures, in exchange for or “in consideration of” receipt of the full $23m “payment.” There is no allocation of the “payment” (a defined term in the settlement agreement meaning both damages for Commonfund’s repudiation and punitive damages) in the terms of the settlement agreement, and the IRS’s attempt to read an artificial allocation “into” the settlement agreement falls on deaf ears with the Tax Court.
Adversarial and Arm’s-Length Negotiations
The Tax Court observes that with regard to the settlement agreement, NCA and Commonfund were “adversarial” and “negotiated at arm’s length” and “in good faith” regarding the nature of the settlement payment, thereby checking all of the Tax Court’s boxes. The fact that the parties were in litigation was, alone, enough to establish the “adversarial” relationship between the parties. Further supporting the “adversarial” nature of the negotiations were the tax implications of settlement.
With respect to the “arm’s-length” and “good faith” elements, the Tax Court observes that the Tax Court will look beyond the terms of an agreement if the facts and circumstances indicate the payment had a different purpose. See Bagley, 105 T.C. at 406. Therefore, when a settlement is “incongruous with the economic realities” of the taxpayer’s underlying claims, the Tax Court will disregard it. See Healthpoint, Ltd. v. Commissioner, T.C. Memo. 2011-241.
The Tax Court debunks the IRS’s rather shortsighted (and wholly self-serving) argument that the settlement agreement was not intended to settle the sale of a joint interest, but instead was intended to settle the state court judgment” of $23m. The Tax Court, however, reminds the IRS that the name of the game is the origin of the underlying claim, which was the repudiation of the joint ventures, and the settlement effectuated a settlement of this underlying claim by NCA’s sale of its interest in the joint ventures to the repudiating party. Just because the state court judgment existed as a claim, it was not the claim that began the whole kerfuffle that was ultimately settled with the settlement agreement.
Tax Adversity and Respecting Allocations
In a final salvo, the IRS argued that the allocation in the settlement agreement should be disregarded because it did not reflect the economic reality dictated that some of the proceeds should have been allocated as punitive damages. The Tax Court patiently explains that it may only disregard an allocation of settlement proceeds if the parties that made the allocation were not adverse as to the tax treatment of those proceeds or if the allocation was not made in good faith. See Robinson, 102 T.C. at 133-134.
Having determined that the parties were tax-adverse, the Tax Court dispenses with this argument post haste. Because the $23m was within the reasonable range of value of the joint venture interests, the Tax Court held that the “economic realities” of the settlement agreement also support the parties’ allocation of the entire amount of the payment to the joint venture interests.
Wrapping NCA Argyle LP up with a Bow
Because NCA received the settlement proceeds in exchange for its joint venture interests, the income from receipt of such proceeds is from the sale of capital assets (the joint venture interests). Further, because the payment was made by adversarial parties (both tax-adverse and litigation-adverse) negotiating at arm’s length, and because the payment was within the reasonable range of value of the joint venture interests, the Tax Court respected the parties’ allocation of all of the payment to the exchange of the capital assets.Add to favorites