The determining factor is the NATURE of the basic claim from which the compromised amount was realized.
Raytheon (original company) was a pioneer manufacturer of rectifier tubes which are used in radio receiving sets (using alternating current instead of batteries). The Radio Corporation of America developed a competitive tube, with the same effect as the Raytheon tube. RCA owned many patents covering radio circuits. Beginning 1927, RCA’s license agreements with radio set manufacturers included a clause which required the manufacturers to buy their tubes only from RCA. Soon, Raytheon’s sales gradually declined.
Raytheon (new company that bought original company) brought an action against RCA for violating anti-trust laws, as well as for destruction of Raytheon’s profitable business and goodwill. Both parties finally agreed on a $410,000 settlement of the anti-trust case, with RCA acquiring patent license rights and sublicensing rights. Raytheon counted the $60,000 from the amount as income from patent licenses, while the remaining $350,000 were counted as damages, and therefore not subject to income tax. The income from patents was determined from the cost of the development of such patents, and the fact that few of them were being used and none were earning royalties. Thus, the value of patents and the goodwill was backed by evidence during trial.
ISSUE: Whether or not damages for loss of business good will are a nontaxable return of capital or income.
HELD: No. They are not taxable in general.
Damages for violation of the anti-trust acts are treated as ordinary income where they represent compensation for loss of profits. The test is not whether the action was one in tort or contract but rather the question to be asked is "In lieu of what were the damages awarded?" Where the suit is not to recover lost profits but is for recovery in injury to good will, the recovery represents a return of capital and, with certain limitations (necessity of proof/evidence), is not taxable.
The suit by Raytheon was not one of recovering lost profits. From its allegations, Raytheon’s suit was for the destruction of its goodwill. The presentation of evidence of profits was merely used to establish the value of good will and the business, since such value is derived by a capitalization of profits. Therefore, a recovery on goodwill and business represents return of capital.
The fact that the case ended in settlement is of no moment. The determining factor is the NATURE of the basic claim from which the compromised amount was realized.
However, compensation for the loss of goodwill in excess of its cost is gross income. The law does not exempt compensatory damages just because they are a return of capital. The tax exemption applies only to the portion that recovers the cost basis of that capital; any excess damages serve to realize prior appreciation, and should be taxed as income. In addition, evidence must be produced to establish the value of the goodwill and business. In this case, Raytheon was not able to establish the value of its goodwill and business. It did not produce enough evidence to such effect. The amount of nontaxable capital cannot be ascertained. Since Raytheon could not establish the cost basis of its good will, its basis will be treated as zero. The Court concludes that the $350,000 of the $410,000 attributable to the suit is thus taxable income.
Note: establishing goodwill can be done as in a situation where a company buys another company, and the buying company allots a certain amount in cost of purchase as goodwill.