Category: Individuals Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Individual taxpayer (TP) was entitled to receive stock of his employer's company in exchange for having produced certain computer software. The stock to be received was in lieu of royalties with respect to the software. Some years later, TP discovered that no stock had been set aside for him and in fact, TP had no stock investment in the employer's company. TP sued for fraud, conversion, and breach of contract. TP ultimately accepted a lump-sum cash settlement in exchange for releasing all of his claims against the former employer. Issue Answer Discussion Application of the origin of the claim doctrine to the present situation yields a very clear answer. TP was entitled to receive something of value (stock) in lieu of royalties on software. There is no question that had TP actually received the stock as promised, the fair market value thereof would have been treated as ordinary income to TP. Accordingly, under the origin of the claim doctrine, TP's present recovery with respect to his claim for having not received the stock should be taxed as ordinary income at least with respect to the amount of the recovery equal to the royalties TP should have received. In our conversation you have stated that no one involved in the case is certain as to the amount of royalty income TP should have received. Accordingly, it is not known with certainty if the amount of the settlement is more or less than the amount of royalty income TP should have received. Assuming, arguendo, the settlement is in excess of TP royalty amount, it is necessary to consider the character of that excess. As stated above, it is my view that any excess should be treated as ordinary income. This is my opinion for two reasons. 1. Capital gain treatment, whether in the context of a lawsuit settlement or not, requires a sale or exchange. IRC §1222. It does not appear to me that the settlement in this case would be viewed as a sale or exchange. TP was supposed to receive stock but did not. Now he has received cash in lieu of the stock. This is entirely different from the typical sale or exchange situation with respect to a lawsuit in which the plaintiff's property is taken or damaged and the proceeds of the lawsuit are in effect in exchange for the original property. Also, Revenue Ruling 74-251, 1974-1 C.B. 234, provides that the mere settlement of a lawsuit does not constitute a sale or exchange. 2. The case of Arcadia Refining Co. v. Comr., 118 F. 2d 1010 (5th Cir. 1941) deals with the case of a recovery with respect to assets taken from the plaintiff. The court held that the excess of the settlement over the fair market value of the assets taken represents earnings on the assets taken and should thus be taxed at ordinary income rates. Applying that logic to this case, if there is any value in excess of TP's royalties, it should logically represent either dividends on the stock or the accretion in the stock's value. Clearly dividends would be treated as ordinary income. It seems also that any increase in the stock's value should be ordinary. Since TP is a cash basis taxpayer, no income would be recognized until TP received cash or its equivalent. Absent an election under §83(b), TP would be taxed at ordinary rates on the full value of any stock received at the time of its receipt. It follows that under the origin of the claim doctrine, the excess portion of the settlement should also be treated as ordinary income. |
