A court of appeals has upheld a Tax Court decision that a sausage manufacturer received ordinary income, rather than capital gain, when it settled a lawsuit involving trade secrets.

In the early 1980s, C&F Packing Co., Inc. (C&F), developed a process for making and freezing pre-cooked sausage that had the appearance and taste of home-cooked sausage. C&F applied for and obtained a patent protecting its new process.

In 1985, Pizza Hut expressed an interest in using sausage made by the C&F process if C&F would agree to share the process with Pizza Hut’s other sausage suppliers so that Pizza Hut could offer its customers a uniform product. The two companies signed an agreement in which C&F disclosed to Pizza Hut information relating to the C&F process, and Pizza Hut promised confidentiality. C&F also entered into separate confidential licensing agreements with several of Pizza Hut’s other suppliers.

Pizza Hut failed to buy sufficient quantities of sausage from C&F and allegedly – it has never admitted wrongdoing – divulged crucial information regarding the C&F process to IBP, Inc., another meat processing company with which C&F had not signed a confidentiality or licensing agreement. IBP replicated the C&F process, set its prices below C&F’s and began selling large quantities of sausage to Pizza Hut. C&F eventually filed suit against both Pizza Hut and IBP, alleging that Pizza Hut misappropriated its trade secrets, causing C&F to suffer lost profits, lost opportunities and operating losses and expenditures.

Pizza Hut and C&F settled the trade secret misappropriation claim with a cash payment to C&F. C&F characterized its $6.12 million as gain from a “trade secret sale” and reported the entire amount as long-term capital gain. The IRS determined that the settlement was ordinary income.

In court, C&F raised three arguments in support of the position that the settlement proceeds should be taxed as long-term capital gain:

1. Relying on cases that held that moneys received for injury or damage to capital assets are taxable as capital gain, C&F argued that the settlement was payment for damage to trade secrets, which are capital assets.

2. Recognizing that long-term capital gain is defined in terms of the “sale or exchange” of capital assets, C&F asserted that the settlement payment represented the culmination of a sale or exchange of the trade secrets related to the C&F process.

3. Looking to the portion of the tax law that treats as capital gain income attributable to the termination of certain rights or obligations, C&F contended that Pizza Hut made the settlement payment to terminate C&F’s rights under the confidentiality agreement the parties signed in 1985.

The Tax Court and the Court of Appeals for the Seventh Circuit rejected all three arguments and sustained the IRS determination that the settlement proceeds should be taxed as ordinary income. In essence, both courts relied on the “origin of the claim” doctrine and viewed the payment as compensating C&F for lost profits. Lost profits result in ordinary income rather than capital gain. (Freda, et. al. v. Commissioner, 108 AFTR 2d 2011-XXXX, Aug. 26, 2011)