Brian L. Nahey and Carol J. Nahey v. Commissioner of Internal Revenue

POSNER, Chief Judge.

This appeal from a decision by the Tax Court against the taxpayers, Brian Nahey and his wife, presents a question that one might (wrongly) have supposed resolved long ere now: if a legal claim for lost corporate income is sold as part of the sale of the corporation, and is later settled, are the proceeds of the settlement ordinary income or capital gain? The Tax Court held they were ordinary income. 111 T.C. 256, 1998 WL 731580 (1998).

Wehr Corporation, a manufacturer of industrial equipment, sued Xerox Corporation for damages arising from Xerox’s alleged breach of a contract with Wehr to sell it a computer system that would satisfy all of Wehr’s data-processing needs. The suit charged fraud as well as simple breach of contract and sought lost profits. Damages in excess of $5 million (including punitive damages) were claimed. Xerox counterclaimed for the unpaid portion of the contract price, some $650,000. While the suit was pending, the majority shareholder in Wehr offered to sell the company to Brian Nahey, its president, for $100 million. The sale took the form of a leveraged buyout (meaning that the assets of the company were pledged to secure a loan that provided the purchaser with the funds necessary to pay the purchase price) by two subchapter S corporations formed and owned by Nahey. (His wife is a party to this litigation only because the couple filed a joint return.) For tax purposes, a sub-chapter S corporation is identical to its shareholders, so we’ll refer to Nahey’s two S corporations simply as “Nahey.” In allocating the $100 million purchase price of Wehr across Wehr’s specific assets, an accounting firm hired by Nahey assigned no value to the suit against Xerox, regarding it as too speculative to be valued.

The sale of Wehr to Nahey took place in 1986. Six years later, the suit (now Na-hey’s) against Xerox was settled. Xerox agreed to pay Nahey $6 million and to dismiss its counterclaim. Nahey concedes that if Wehr hadn’t been sold, and if it had settled its suit against Xerox on the same terms that Nahey did, the entire settlement price of $6 million would have been taxed to Wehr as ordinary income rather than as a capital gain because the amount received in the settlement would have replaced ordinary income of which Xerox had deprived Wehr. Alexander v. Commissioner, 72 F.3d 938, 942-44 (1st Cir.1995). (The rule is arbitrarily different in the case of suits for personal injuries; only punitive damages are taxable in such eases even if the judgment or settlement is mainly for lost earnings that would have been ordinary income if not lost because of disability caused by the defendant’s wrongdoing. 26 U.S.C. § 104(a); see O’Gilvie v. United States, 519 U.S. 79, 86, 117 S.Ct. 452, 136 L.Ed.2d 454 (1996); 1 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates, and Gifts ¶ 13.1.4 (3d ed.1999).) If the settlement proceeds had replaced a capital gain, they would have been taxed as a capital gain. Anchor Coupling Co. v. United States, 427 F.2d 429, 433-34 (7th Cir.1970). That is all that Anchor Coupling, on which Nahey relies, held, and it doesn’t help him since the origin of his claim was a claim to ordinary income, not to a capital gain.

It is true that when a taxpayer sells a capital asset, the income he receives from the sale is a capital gain. 26 U.S.C. §§ 1221, 1222. And we may assume that the suit against Xerox was a capital asset of Wehr and was acquired together with Wehr’s other assets in the purchase of the corporation by Nahey. A capital asset is “property held by the taxpayer,” 26 U.S.C. § 1221; Arkansas Best Corp. v. Commissioner, 485 U.S. 212, 217-18, 108 S.Ct. 971, 99 L.Ed.2d 183 (1988), and while there are exceptions in section 1221 none of them embraces legal claims, although there is some authority for refusing to classify a right to ordinary income as a capital asset, see id. at 217 n. 5, 108 S.Ct. 971, and Wehr’s claim against Xerox could be so characterized. That is why we are merely assuming that a sale of the claim would have produced a capital gain, rather than ordinary income, to Wehr. For the sake of completeness we add that, on this assumption, the fact that the accountants declined to value this asset because it was speculative would not undermine its character as a capital asset; it would merely give it a zero basis.

But even if the sale of the suit would have produced capital gain (or loss) to the seller, the purchaser, when he prosecuted the suit to judgment and collected the judgment, or when he settled the case and received the proceeds of the settlement, would be taxable on the net gain at the ordinary-income rate. Ogilvie v. Commissioner, 216 F.2d 748 (6th Cir.1954) (per curiam). This is critical because Nahey did not sell the suit; he prosecuted it to settlement himself. The settlement proceeds were therefore ordinary income to him. A settlement, or equally a litigated judgment, resembles a sale because it extinguishes the plaintiffs claim. But our hypothetical example shows the difference between assigning and enforcing a legal claim. If a settlement or judgment were the sale of an asset, then had Wehr not been sold to Nahey, but had instead obtained the settlement with Xerox itself, the proceeds would (we’re assuming) be a capital gain to Wehr — yet Nahey concedes that they would be ordinary income to Wehr. The concession is compelled by the principle that “the [tax] classification of amounts received in settlement of litigation is to be determined by the nature and basis of the action settled, and amounts received in compromise of a claim must be considered as having the same nature as the right compromised.” Alexander v. Commissioner, supra, 72 F.3d at 942.

To nail this point down, let’s suppose Wehr had owned a $1,000 face-amount coupon bond due in 1992 and paying 5 percent annual interest, and the accountants had valued it at $1,000 in the sale of Wehr’s assets to Nahey. Between 1986 and 1992, Nahey would have clipped the coupons and received interest of $50 per year ($500 in total) taxable as ordinary income. Then in 1992 he would have cashed in the bond for its face amount, a nontaxable return of principal. Compare that to a variant of this case in which the accountants value the suit against Xerox at $1 million. Then $1 million of the $6 million would have been the cost of the asset to Nahey and would be deducted from the proceeds of the settlement in computing Nahey’s income from the settlement. The balance of $5 million would be ordinary income, just like the interest on the bond. It shouldn’t make a difference that Wisconsin law (the governing law in the Xerox case) cut off Nahey’s right to recover for Wehr’s lost profits as of the date of the sale of the corporation to him, while in the case of the bond the interest is received after the acquisition. The proceeds of the settlement were received after the settlement, just as the interest on the bond was received after the bond was purchased. The proceeds of the settlement represented overdue ordinary income, but that didn’t make it a capital gain. In both cases, what was transferred as part of a corporate acquisition was an asset that yields ordinary income, an asset that the purchaser as it were “milks” for that income rather than selling the asset.

Lest the foregoing analysis seem too formalistic for some tastes, we add that we cannot find any practical reason for why the tax treatment of the proceeds of a suit should change merely because of an intervening change in ownership. Recall the taxpayers’ concession that if Wehr had obtained the settlement the proceeds would have been taxable to Wehr as ordinary income, not as a capital gain. Recall too that if Wehr had assigned the suit to someone else, that someone else would have had to pay tax on the net proceeds from any settlement or judgment (net, that is, of the price of the assignment) at ordinary-income rather than capital-gains rates. Why should it make a difference that the assignment was packaged with a sale of other assets (the rest of Wehr’s assets) as well? Canal-Randolph Corp. v. United States, 568 F.2d 28, 30, 33 (7th Cir.1977) (per curiam), assumes that it makes no difference, consistent with the principle that a merger or other corporate acquisition does not alter the tax status of the assets involved in it. E.g., United States v. Hilton Hotels Corp., 397 U.S. 580, 90 S.Ct. 1307, 25 L.Ed.2d 585 (1970).

The only effect of permitting the assignment to change the tax classification of the eventual proceeds would be to give an owner of legal claims an incentive to spin them off into a new corporation and sell the corporation, rather than selling the claims directly. The attempt to obtain favorable tax treatment for the purchaser (and hence a higher purchase price) by this route might be thwarted by the “substance over form” doctrine, see, e.g., Yosha v. Commissioner, 861 F.2d 494, 497-98 (7th Cir.1988), but why invite that complication? Why create an added incentive for corporate reorganizations (have we a shortage of them?), which would be the consequence of the rule for which the taxpayers contend in any case in which a corporation has substantial assets in the form of legal claims the enforcement of which would yield ordinary income to the corporation.

Sometimes when a company is sold, the seller retains some or all of its legal claims (more commonly, its legal liabilities, as in Chaveriat v. Williams Pipe Line Co., 11 F.3d 1420, 1424 (7th Cir.1993)), for example by spinning off the claims into a newly formed corporation, because the purchaser may not be able to form a good idea of their merits or may fear the contingent liabilities that the prosecution of a claim often entails — remember Xerox’s counterclaim, which depending on the court’s rulings might have ended up being worth more than Wehr’s claim. Why complicate and distort the business judgment of the parties as to whether to retain or assign legal claims by creating a tax incentive to assign them?

In an effort to bring himself within Anchor Coupling, Nahey argues that the claim which was settled was capital in origin, the origin being the LBO. But that is just a conclusion. It is more sensible, for the reasons just explained, as well as fully compliant with the legal formalities, to regard the LBO as merely an intermediate transaction between the original claim, which was to recover ordinary income of which Wehr had been wrongfully deprived, and the settlement of that claim after its transfer to Nahey.

It is desirable that rules of taxation be simple and that they be neutral, in the sense of not influencing business judgments except when the purpose of a particular provision of tax law is to influence behavior, which is not contended to be the case here. Judged by this twofold standard the Tax Court’s decision is sound; a corporate acquisition should not affect the tax treatment of any claims that are transferred in the acquisition. Against this the taxpayers point to cases in which the government successfully argued that a deduction taken with respect to an asset acquired as part of a corporate acquisition was a capital loss. The leading case is Arrowsmith v. Commissioner, 344 U.S. 6, 73 S.Ct. 71, 97 L.Ed. 6 (1952), but as explained in United States v. Skelly Oil Co., 394 U.S. 678, 685, 89 S.Ct. 1379, 22 L.Ed.2d 642 (1969), all it stands for is the unexceptionable proposition that “if money was taxed at a special lower rate when received, the taxpayer would be accorded an unfair tax windfall if repayments [of that money] were generally deductible from receipts taxable at the higher rate applicable to ordinary income.” See also 2 Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates and Gifts § 52.1.9, p. 52-19 (2d ed.1990). That proposition underlies the Tax Court’s decision in this case, which merely requires that the tax classification of a legal claim remain unaltered through transfer of the claim whether by assignment or as an incident to a corporate acquisition or other reorganization.

Suppose that Nahey had sold the suit against Xerox rather than prosecuting it and had incurred an expense of $10,000 in negotiating the sale, and that the gain on the sale was taxable at capital-gain rates. He would not be permitted to deduct that expense from ordinary income; he would have to deduct it from the sale price and thus reduce his capital gain rather than his ordinary income. Woodward v. Commissioner, 397 U.S. 572, 578, 90 S.Ct. 1302, 25 L.Ed.2d 577 (1970). In some of the cases that Nahey cites, the court may have misclassifíed an expenditure (he points chiefly to Pacific Transport Co. v. Commissioner, 483 F.2d 209 (9th Cir.1973) (per curiam)), and treated an ordinary expense as a capital one. If so (which we needn’t decide), those cases are incorrect; but there is no principle that an incorrect decision creates a right in a taxpayer to whom that decision has never been applied. Should the government ever claim that the legal expenses incurred by Nahey in obtaining the settlement were capital rather than ordinary — a contention the government’s lawyer disclaimed at argument — the Tax Court will be required to reject the contention.

Nahey tries to fit the case into the “open transactions” doctrine, which in its simplest version allows a person who sells property in exchange for a stream of payments contingent on the profits generated by the property to treat the stream as a capital gain, though it looks like ordinary income. The doctrine is designed for cases in which neither the property nor the contingent mode of payment for it can be valued at the time of the sale, so that the taxpayer cannot be accused of having attempted to transform ordinary income into a capital gain; he took the capital gain in the only form that was feasible. 2 Bittker & Lokken, supra, § 52.1.9, p. 52-18. The doctrine presupposes that if the property could have been sold for a definite sum, that sum would have been taxable as a capital gain, not ordinary income. Had Wehr sold its claim against Xerox (whether directly or through a corporate reorganization) to Nahey in exchange for a “cut” of any judgment or settlement proceeds, and if — the question we left open earlier — the sale of a legal claim to ordinary income can ever yield a capital gain rather than ordinary income to the seller, then conceivably Wehr could have treated that “cut” when received as a capital gain. But the issue is Nahey’s tax liability, and to that the open transactions doctrine is irrelevant.

AFFIRMED.