Settlement Claims Are Not Capital Gains, Federal Circuit Rules

By Jonathan R. Tung, Esq. on January 27, 2016 | Last updated on March 21, 2019

As if guiding taxpayers away from the hazards of the tax code, the Federal Circuit drew a line: settlement payments are not capital gains; they're regular income.

The difference between capital gain and regular income is material when the different tax liabilities are taken into account. In either case, settlements paid in exchange for someone to go away do not qualify as a "sale or exchange of a capital asset."

Income or Capital Gain?

In the case at bar, a plaintiff called off his employment discrimination claim against his former employer in exchange for a settlement payment from the company. He worked as a consultant. While doing his taxes, he first filed his settlement payment as regular income. Then he later amended his return and reclassified the settlement proceeds as a capital gains.

The IRS denied his reclassification and the consultant challenged the IRS in the Court of Federal Claims. The government won. On appeal, the government won again.

I.R.C. sec. 1221(1), (3)

A capital gain is defined by Internal Revenue Code sec. 1221 as a "gain from the sale or exchange of a capital asset." So, the preferential capital gains rate is out of reach for those people who cannot prove that a "capital asset" was sold.

For most people, the usual meaning covers the sale of personal goods that one can see and touch, as well as assets of the equity variety: stocks, bonds, ETFs, and other securities.

The consultant pushed the idea that the settlement income actually represented restitution for goodwill that he lost in his financial consulting business. Although it was possible for a sale of goodwill to occur, it had in the past only occurred when the goodwill was being sold with the business, dust mites and all. Since there was no sale of the business, that case law would not help the consultant.

Go Away

Additionally, the court relied on the language of the Sixth Circuit case National-Standard Co. v. Commissioner: "where one party to the transaction receives neither property nor money or its equivalent, there is no 'sale or exchange'." In this case, the former employer received no such property -- it only gained the relief of the consultant going away.

But seriously ... isn't it a "money equivalent" to get a previously litigious party to back off and leave you alone? Guess not.

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