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Employment-discrimination settlement wasn’t entitled to capital-gain tax rate


Duffy v. U.S., (Fed Cir 1/8/2016) 117 AFTR 2d ¶ 2016-324

The Court of Appeals for the Federal Circuit, affirming the Court of Federal Claims, has concluded that the settlement payments from an employment discrimination suit received by an individual—who had owned a consulting business but then became an employee—weren’t capital gain income. The payments didn’t represent gain from the sale or exchange of goodwill associated with a capital asset, but rather were for exclusive purpose of avoiding the expense and inconvenience of further litigation.

Background. “Capital gain” (whether short-or long-term) is defined as gain from the sale or exchange of a capital asset. (Code Sec. 1222(1), Code Sec. 1222(3))

The Supreme Court has interpreted “sale” and “exchange” to require the transfer of property, either for money (or its equivalent) in the case of a “sale” or for reciprocal property in the case of an “exchange.” (Brown, (S Ct 1965) 15 AFTR 2d 79015 AFTR 2d 790; William Flaccus Oak Leather Co, (S Ct 1941) 25 AFTR 123625 AFTR 1236; Nat’l-Standard Co., (CA 6 1984) 55 AFTR 2d 85-47055 AFTR 2d 85-470)

Code Sec. 1221(a) provides that the term “capital asset” means property held by the taxpayer (whether or not connected with a trade or business), but does not include items described in Code Sec. 1221(a)(1) through Code Sec. 1221(a)(8).

Several courts have held that the sale of goodwill occurs only when the business, or a part of it to which the goodwill attaches, is sold. (Elliott, (CA 10 1970) 26 AFTR 2d 70-547326 AFTR 2d 70-5473; Baker, (CA 7 2003) 92 AFTR 2d 2003-564092 AFTR 2d 2003-5640)

Facts. From ’99 to 2004, James Duffy owned his own business providing consulting on tax and accounting matters. In 2004, he was employed by United Commercial Bank (Bank) as its Tax Director and First Vice President. His responsibilities included seeing that his department complied with the accounting and financial-disclosure requirements of the Sarbanes-Oxley Act. In 2006, he informed the Bank’s management that he saw instances of noncompliance with that Act. Soon afterwards, the Bank placed him on administrative leave and then terminated his employment. He filed a claim against the Bank with the Department of Labor (DOL), alleging that the Bank terminated his employment because of his whistleblower activity and retaliated against him for his refusal to participate in the Bank’s illegal conduct.

Mr. Duffy and the Bank entered into a settlement agreement. Under the agreement, the Bank agreed to pay $50,000 directly to Mr. Duffy and $25,000 to his attorneys on his behalf. In exchange, Mr. Duffy’s termination from the Bank became permanent, and he immediately withdrew all of his claims against the Bank pending before the DOL. He stipulated that he would be solely responsible for his tax liabilities relating to his receipt of the Bank’s payment and that the Bank made no representations about the tax treatment of that payment. The agreement explicitly noted that it was entered into “for the exclusive purpose of avoiding the expense and inconvenience of further litigation.”

Mr. Duffy filed his federal income-tax return, listing the $50,000 settlement payment as “other taxable income,” and received a refund of $1,500. However, coming to believe that the settlement payment should not have been listed as income, he filed two amended tax returns seeking a refund of $13,049. He contended that the settlement proceeds should be treated either as compensation for physical injury (excludable from income under Code Sec. 104(a)(2)) or as capital-gain income for lost goodwill of his financial consulting business.

IRS disallowed the refund, stating that the $50,000 non-employee compensation from Bank was taxable as originally filed. Mr. Duffy sought relief in the Court of Federal Claims.

Decision of the Court of Federal Claims. The Court of Federal Claims determined that the settlement proceeds should not be treated as capital-gain income, reasoning that because there was no sale or exchange of business goodwill (the only possible capital asset identified by Mr. Duffy), there could be no capital gain under Code Sec. 1222. The Court also rejected Mr. Duffy’s claim that the settlement proceeds could be treated as non-taxable compensation for physical injury (a ruling that Mr. Duffy did not appeal).

Decision of the Federal Circuit. Affirming the lower court, the Federal Circuit found that Mr. Duffy wasn’t entitled to a preferential capital-gain tax rate for the payment he received because, even if the goodwill in his consulting business qualified as a “capital asset,” he failed to show that the settlement payment was received in a “sale or exchange” of that goodwill.

The Court reasoned that where one party to the transaction receives neither property nor money or its equivalent, there was no “sale or exchange.” In this case, no property was transferred to the Bank. Instead, the Bank agreed to a settlement payment in exchange for Mr. Duffy abandoning his employment discrimination claims. Mr. Duffy simply extinguished his claims, and any goodwill in his business remained with him.

The Court concluded that goodwill cannot be transferred apart from the business with which it is connected, and that there was no sale of Mr. Duffy’s business, in whole or in part. The Court noted that Mr. Duffy’s complaint filed with the DOL made no reference to the goodwill of his consulting business, but instead focused on his termination as an employee for making disclosures protected by the Sarbanes-Oxley Act. Further, the settlement agreement nowhere mentioned that any part of the proceeds from the Bank constituted compensation for harm to the goodwill of his private business. In fact, the agreement stated that its exclusive purpose was to avoid the expense and inconvenience of further litigation on Mr. Duffy’s claim.

References: For sale or exchange of a capital asset, see FTC 2d/FIN ¶  I-1002  ; United States Tax Reporter ¶  12,224.15  ; TaxDesk ¶  220,201  ; TG ¶  10051  .

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