Misallocation of damages has tax consequences

Healthpoint, Ltd. v. Commissioner, T.C. Memo. 2011-241, 2011 WL 4550112 (U.S. Tax Ct.)

I don’t think I’ve ever blogged a tax case before, but this involved the proceeds of a settlement agreement in a false advertising case. Healthpoint is a specialty pharmaco which sold, among other things, a successful prescription ointment called Accuzyme. Ethex introduced Ethezyme, marketed as a generic form of Accuzyme, but with an additional potentially harmful chemical and more active ingredient. This caused Healthpoint economic damage, and it sued for false advertising, unfair competition, and related claims. Actually, it sued twice, for new claims about a new formulation of Ethezyme that came too late to add to the older case.

The jury in the first case ruled for Healthpoint, finding false advertising and additionally finding that Ethex acted with malice under Texas law, though rejecting claims that Ethex had knowingly or intentionally diluted Healthpoint's trademark or disparaged Healthpoint's business. The jury awarded over $16 million, $5 million in actual damages, over $1.6 million in disgorgement of profits, over $3.1 million in punitive damages, and over $6.3 million in enhanced damages under the Lanham Act.

In the end, the parties settled the first case for $12 million and the second for $4.5 million. The parties agreed to a nondisparagement clause that permitted Healthpoint to use public domain documents to promote Accuzyme and distinguish it from Ethezyme, coupled with terms that prohibited Ethex from using the settlement agreement for those same purposes. Ethex proposed allocating $12 million to "compensatory damages arising out of alleged unintentional product disparagement" to settle Ethex I and $4.5 million with the same description to settle Ethex II.

Healthpoint’s tax counsel prepared an outline of the categories of damages, but didn’t assign amounts; Healthpoint then proposed a different allocation. Ethex refused to settle with any public statement “that might be associated with willful misconduct. We feel strongly that this characterization of our conduct is completely unjustified. These accusations have been injurious to our reputation, and we will not do anything that might be interpreted as conceding that we acted in a knowing manner.” Healthpoint subsequently acquiesced to Ethex's demand to eliminate allocations to misappropriation and punitive damages.

The ultimate agreement allocated damages in Ethex I of $10.45 million to damage to goodwill and reputation, and $1.35 million to lost profits/disgorgement. The corresponding figures for Ethex II were $4.05 million/$450,000. The settlement agreement also included the statement that "no part of the sums paid pursuant to this Agreement are for willful misconduct" or for punitive damages. There was also a nondisparagement clause that allowed Healthpoint to use publicly available documents from the lawsuit to distinguish the parties’ products.

Healthpoint didn’t have any business documentation of the goodwill or make any calculations during settlement negotiations to justify the allocations. It was aware of the potential tax benefits of characterizing money as capital gain, but its tax counsel wasn’t involved in the allocation.

Healthpoint reported $14.5 million in long-term capital gains from the settlement and $1.8 million in ordinary income. The IRS disagreed, though eventually conceded that the over $6.3 million in enhanced Lanham Act damages awarded by the jury in Ethex I were taxable as long-term capital gains.

Healthpoint argued that the IRS should respect the allocations made in the settlement agreement. Proceeds for goodwill or damage to reputation are taxable as capital gain, while proceeds determined to be lost or disgorged profits or punitive damages are taxable as ordinary income. The rule is that the tax consequences of damages received under a settlement depend on the nature of the claim that was the basis for the settlement, not the validity of the claim. An express allocation in the settlement agreement is generally followed if it was entered into at arm’s length and in good faith, but isn’t determinative if other facts indicate that the payments were for a different purpose.

In particular, the fact that a defendant didn’t desire to admit that it was paying punitive damages isn’t dispositive where there’s solid evidence that the prospect of punitive damages increased the amount the defendant paid in settlement. Though the parties were generally adverse, if they ultimately allocated the funds in a way that did not represent the claims they actually intended to settle, then the tax treatment need not respect the allocations made in the settlement agreement.

Here, Ethex refused to pay any amount labeled as punitive damages, but it still paid a negotiated sum. “Ethex was indifferent as to how Healthpoint chose to allocate the funds so long as the allocation did not imply intentional wrongdoing, and it permitted Healthpoint to assign the same amount of damages to any other category.” Thus, the allocations weren’t the product of negotiations between adverse parties. Healthpoint was aware that the proposed allocations would result in a more favorable tax rate, and the tax benefits were of more value to it than being able to tout that it had received punitive damages under the nondisparagement agreement. It proposed an allocation to punitive damages that was significantly less than the amount of the jury award, suggesting that tax considerations were foremost.

A jury verdict is the best indicator of the worth of a plaintiff’s claims, so, in light of the facts, the allocations made by the jury in Ethex I should be applied to that part of the settlement. There was never a jury verdict in Ethex II, though. But because the cases were very similar, and the settlement agreement allocated the damages in similar proportions, damages should be allocated in the same proportions.

This result also triggered an accuracy-related penalty for Healthpoint.

So, practice tip: consider the tax consequences of settlement—but have non-tax-related reasons for making the allocations you make!