Freda v. Commissioner, No. 10-1555 (7th Cir. 2011)
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A sausage manufacturer brought claims against its former business partner, Pizza Hut, in 1993. In 2002 the manufacturer agreed to drop its last remaining claim, trade secret misappropriation, in exchange for a $15.3 million payment. When it received its $6.12 million take-home portion of the settlement, C&F, a shareholder and an S corporation, reported the income as long-term capital gain. Its shareholders reported their passed-through pro rata shares the same way. The IRS concluded that the settlement income should have been taxed as ordinary income and issued each of the shareholders a deficiency notice. The tax court and Seventh Circuit affirmed. The tax court found that Pizza Hut paid for lost profits, lost opportunities, operating losses and expenditures and rightly concluded that the settlement did not represent the final phase of a 13-year-long transfer of a capital asset. Because there was not a complete transfer of all substantial rights, there was no sale of a capital asset or long-term capital gain resulting therefrom.
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