Generally, recoveries under contract rights are taxable as ordinary income. The reasoning here is that a failure to perform by one of the contracting parties typically gives rise to a loss of ordinary income.
Some exceptions exist, however. For example, in cases where a breach of contract involves a capital asset—such as goodwill or stock—that the portion of the recovery will be taxed at capital gains rates if certain burdens of proof are met. The taxpayer must show that (i) the breach involved harm to a capital asset, (ii) that the portion of the recovery to be taxed at capital gains rates is directly attributable to that asset, and (iii) is the actual basis of that asset.
If the taxpayer cannot establish all these elements, the entire recovery is likely to be treated as ordinary income. This is what happened in Raytheon Corp. v. Commissioner, 144 F.2d 110 (1944), where the taxpayer received damages from RCA in settlement of an antitrust suit. The taxpayer was able to establish its basis in certain capital assets such as its patent and license rights, but the court held that with respect to the portion of the damages received for assets where the taxpayer could not establish its basis such as goodwill, that amount would be taxed at ordinary income rates.
Furthermore, if the recovery provides compensation for the use of the capital asset—as opposed to harm to the asset—then the recovery will be taxable as ordinary income. Determining the tax treatment of the recovery will involve the “original of the claim test.” By way of example, in Keller Street Development Co. v. Commissioner, 688 F.2d 675 (1982), the taxpayer received a settlement from the buyer of his brewery in regards to a minority shareholder derivative suit. The taxpayer treated the recovery as an adjustment in the sale price of the brewery. Although gain from the sale of the brewery constituted capital gain, the court held that the recovery was taxable as ordinary income because it compensated the taxpayer for the buyer’s use of the brewery during the 10 years of litigation.
Therefore, even where a contract primarily involves the sale or exchange of a capital asset, to the extent the recovery provides compensation for the use of the capital asset it will likely be taxed as ordinary income.
Tax consequences of a recovery from a contract dispute was last modified: April 16th, 2019 by David Klasing