That’s what Healthpoint wound up with when they settled an infringement suit against Ethex, in Healthpoint, Ltd., DFB Pharmaceuticals, Inc., Tax Matters Partner, 2011 T.C. Mem 241, released 10/3/11.
Healthpoint sued Ethex for ripping off Healthpoint’s great debrider (which is a drug that removes necrotic tissue), adulterating the formula and thereby trashing Healthpoint’s sales and goodwill. Healthpoint won a great jury verdict, sued Ethex for more of the same, Ethex appealed lawsuit one, and after much legal whammer-jammer, Ethex settled both cases and paid Healthpoint big bucks.
Now for the tax issue: what part of the settlement money is for damage to goodwill, and what for lost profits? The former is long-term capital gain, the latter is ordinary income. So guess where 90% of the money was allocated in the settlement agreement? Of course tax counsel wasn’t consulted.
Healthpoint argues that, as the parties are adversaries and at arms’-length, and as Ethex fought vigorously against admitting guilt or paying punitives, their allocation should be respected. Nope, says Judge Cohen: “Healthpoint did not maintain any business documentation relating to goodwill or make any calculations during the settlement negotiations to justify the allocations in the agreement. Healthpoint was aware that allocating money to items of ordinary income rather than capital gain would generate a higher tax burden. Healthpoint’s tax counsel was not involved in any discussion of the total amount of the settlement or the amount of each individual allocation.” 2011 T.C. Mem. 241, at p.9.
The point is, what claims did the parties really settle, not what did they say they settled? Judge Cohen again: “…general adversity between the parties to a lawsuit is to be expected. The requirement that parties involved in settlement negotiations be adverse is a factor in determining whether the final agreement reflected the true intentions of the parties involved. 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.” 2011 T.C. Mem. 241, at p. 13.
Ethex didn’t care how Healthpoint characterized the money Ethex paid, as long as the characterization didn’t inculpate Ethex. Judge Cohen: “We agree with respondent [IRS] that, in the light of the circumstances of the settlement and the verdict in Ethex I, the allocations made by the jury should be applied to the settlement of Ethex I for tax purposes. However, we must still address the allocations with respect to Ethex II. ‘When assessing the tax implications of a settlement agreement, courts should * * *[not] engage in speculation’, but should discern ‘the claim the parties, in good faith, intended to settle for.’. [Citations omitted.] 2011 T.C. Mem 241, at p. 16.
Remember, Healthpoint won a jury verdict in the first lawsuit, but settled both before the second went to trial.
Treat ‘em alike, says Judge Cohen: “Although Healthpoint’s complaint in Ethex II alleged misdeeds by Ethex slightly different from those alleged in Ethex I, the cases were very similar. In fact, the settlement agreement allocated the damages in Ethex I in similar proportions to Ethex II.
“Petitioner has not met its burden to show that the allocations according to the settlement agreement in Ethex II should be respected. The amounts paid to settle Ethex II should be allocated in the same proportions and classifications as those in Ethex I, on the basis of the jury verdict, the above analysis, and respondent’s concession.” 2011 T.C. Mem 241, at pp. 16-17.
Takeaway for trial counsel: Talk to tax counsel when you craft your settlements. Don’t get carried away by the joy of victory, lest you later suffer the agony of defeat.