FREDA v. COMMISSIONER OF INTERNAL REVENUE (August 26, 2011)

In 1985, Pizza Hut wanted to switch to a sausage made under a process developed by C&F. Since C&F could not satisfy Pizza Hut’s purchase needs, C&F disclosed its process to Pizza Hut under a confidentiality agreement and also licensed its process to several of Pizza Hut's other suppliers. C&F brought suit against Pizza Hut and IBP in 1993, alleging that Pizza Hut shared the sausage process with IBP without a license agreement and started buying its sausage from IBP. It alleged that Pizza Hut misappropriated and disclosed trade secrets and that it suffered lost profits and lost opportunities. The district court dismissed the claims against Pizza Hut but assessed over $10 million in damages against IBP. After an appellate court affirmed the damages award, IBP paid the judgment. C&F treated $2.86 million of the judgment as ordinary income on its determination that that reflected its lost profits. It treated the rest as capital gains. The appellate court also reversed the dismissal of Pizza Hut and remanded the case. The parties settled that claim for $15 million. C&F characterized the $6 million it realized from the settlement as a trade secret sale and reported it as long-term capital gain. Its shareholders did the same. The Commissioner of Internal Revenue issued notices of deficiency to the shareholders, asserting that the $6 million should be treated as ordinary income. After a one-day trial, Judge Chiechi (U.S. Tax Ct.) sustained the Commissioner’s determination. The court rejected the arguments that the settlement proceeds were for damage to a capital asset (C&F's trade secrets) and that the settlement proceeds reflected the sale of a capital asset.

In their opinion, Seventh Circuit Judges Flaum, Manion (dissenting), and Tinder affirmed. Although the Court conceded that the "origin of the claim" doctrine was not directly applicable, it concluded that its underlying principles were. Under that doctrine, settlement proceeds are to be classified based on the nature of the action settled. The Court concluded that the Tax Court's finding of fact that the settlement was for lost profits, lost opportunities, operating losses, and expenditures was not clearly erroneous. Under that finding, the shareholders' argument that the settlement was for damages to a capital asset was rejected. The shareholders had the burden of demonstrating that the settlement proceeds were for something other than that. That they failed to do. The Court also rejected the sale of a capital asset argument. It found no support in the record for such a conclusion.

Judge Manion dissented. Although he concurred with the panel's treatment of the asset sale argument, he believed that the settlement proceeds should be treated as a recovery of value lost when a trade secret was misappropriated. Under his understanding, the Tax Court misread the complaint. Although the complaint did seek lost profits, Judge Manion pointed out that the complaint was filed against both Pizza Hut and IBP. The claim against IBP was for lost profits. The claim remaining after the IBP settlement was a trade secret misappropriation claim. The Pizza Hut settlement was compensation for its diminished value and should have been treated as capital gains.