Oftentimes in life, we say things merely because they appear to reflect conventional wisdom, regardless of whether we’ve ever actually independently verified their validity. Things like:
“Meryl Streep is the greatest actress of her generation.”
“He may enjoy lukewarm commercial success, but Beck is an extraordinarily talented musician.”
“Anything bigger than a handful, and you’re risking a sprained thumb.”
It’s no different in the tax world. For example, tax advisors almost universally offer up the following advice to clients seeking guidance on how to characterize the gain from the sale of assets or payments received as a result of a legal settlement:
“As long as you’ve got a bargained for, arms-length agreement with an unrelated party, the IRS won’t attack your allocation.”
Unfortunately, as Healthpoint, LTD., DFB Pharmaceuticals, Inc. v Commissioner, T.C. Memo 2011-241 reminded us today, just because we say it, doesn’t make it true.
In Healthpoint,the taxpayer was a pharmaceutical partnership that manufactured and marketed a very successful drug; Accuzyme. A competitor came along and introduced Ethezyme, a drug that was marketed as a generic form of Accuzyme. Unfortunately, Ethezyme also contained a potentially harmful chemical that sickened patients. Once word got out, the damage wasn’t limited to the manufacturer of Ethezyme, however, as their marketing strategy had been rather successful. As a result, when the reputation of Ethezyme suffered, so did the reputation of Accuzyme, as in the eyes of the public, the drugs were one and the same.
In response, Healthpoint filed two separate suits against the competitor, alleging false advertising, unfair competition, and trademark dilution. Healthpoint won the first suit, with a jury awarding the company $16,100,000. The jury allocated the damages as follows:
Actual damages: $5,000,000 Lost profits: $1,640,00 Punitive damages: $3,1745,000 Damage to goodwill: $6,349,000
While the second suit was in deliberation, the competitor filed an appeal with regards to the first suit. Healthpoint decided the best course of action was to pursue a settlement of both suits at once.
After much negotiation, the two parties agreed to settle, with Healthpoint receiving $16,300,000 between the two suits. Both parties had a vested interest in refraining from calling the bulk of the settlement punitive or compensatory damages: the competitor because an admission of wrongdoing would only further damage their already sullied reputation, and Healthpoint because any punitive or compensatory damages would generate ordinary income.
In light of these facts, a final settlement agreement was executed allocating the $16,300,000 as follows:
Lost profits: $1,800,000 Damage to goodwill: $14,5oo,00o
On its Form 1065 for the year of settlement, Healthpoint reported the $14,500,000 as long-term capital gain, and the $1,800,000 of lost profits as ordinary income. The IRS challenged the characterization, arguing that the allocation of the settlement income should follow the allocation provided for by the jury upon Healthpoint’s victory in the initial suit. This would effectively recharacterize $9,000,000 of the settlement payment from capital gain to ordinary income.
Healthpoint disagreed, repeating the long-held belief that the IRS and the Tax Court should respect the allocations provided for in the final, executed settlement agreement.
The Tax Court, likely to the surprise of many CPAs, sided with the IRS, choosing to ignore the executed settlement agreement between two unrelated parties. In reaching its decision, the court stated:
Where there is an express allocation in the settlement agreement between the parties, it will generally be followed in determining the allocation for Federal income tax purposes if the settlement agreement is entered into by the parties in an adversarial context at arm’s length and in good faith.
The Tax Court then backtracked by adding:
However, general adversity between the parties to a lawsuit is to be expected. If the parties were generally adverse but ultimately allocated the funds in a way that did not represent the claims they actually intended to settle, then we need not respect the allocations made in the settlement agreement.
The court determined that while Healthpoint and its competitor may had been adverse parties, they both benefitted from characterizing the bulk of the settlement payment as harm to goodwill rather than punitive or compensatory damages: the competitor could salvage its reputation; Healthpoint could benefit from the long-term capital gain rates. Because both parties wanted to avoid calling the settlement payment damages, the court held that the allocation could not be respected.
Instead, the Tax Court required that Healthpoint characterize the income in the same manner as was handed down by the jury in the first suit. As a result, over $9,000,000 of the $16,200,000 payment was treated as ordinary income.
What Can We Learn? The decision in Healthpoint will prove difficult for a majority of CPAs to get their arms around. If we are presented with a signed, fully executed settlement agreement between two unrelated parties that has been negotiated at an arm’s length, we will rarely – if ever — dig any deeper than the document itself. In many cases, we are not even privy or party to the negotiations; rather, we are merely presented with the final agreement and charged with accurately presenting it on a tax return.
Well, in Healthpoint, not only did the court dig deeper than a CPA may feel necessary, the taxpayer was also held liable for a substantial underpayment penalty. In refusing to apply the “reasonable cause” exception, the court noted that Healthpoint’s tax adviser was not asked to opine on the propriety of the allocations in the agreement, nor did he participate actively in the negotiations.
This should serve as an eye-opener to tax advisers everywhere. To best protect our clients from exposure to additional assessments of tax and the associated underpayment penalties, we may need to insist on being an active part of any negotiation that ultimately dictates the characterization of income on a client’s tax return.
In closing, Beck sucks.