Freda v. Comm'r of Internal Revenue

• Citation: 656 F.3d 570,108 A.F.T.R.2d 2011,99 U.S.P.Q.2d 1946
• Decision Date: 26 August 2011
• Docket Number: No. 10–1555.,10–1555.
• Parties: Joseph A. FREDA, et al, Petitioners–Appellants,v.COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (7th Circuit)

656 F.3d 570
108 A.F.T.R.2d 2011-5985
99 U.S.P.Q.2d 1946

Joseph A. FREDA, et al, Petitioners–Appellants,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent–Appellee.

No. 10–1555.

United States Court of Appeals, Seventh Circuit.

Argued Sept. 30, 2010.Decided Aug. 26, 2011.

[656 F.3d 570]

Jenny Louise Johnson (argued), Attorney, Holland & Knight, Chicago, IL, for Petitioners–Appellants.Andrew M. Weiner, Attorney, Department of Justice, Tax Division, Appellate Section, Washington, DC, for Respondent–Appellee.Before FLAUM, MANION, and TINDER, Circuit Judges.TINDER, Circuit Judge.

Sausage manufacturer C & F Packing Co., Inc., brought a variety of claims against its former business partner, Pizza Hut, Inc., in 1993. After a trial, a trip to the United States Court of Appeals for the Federal Circuit, and a lot of legal wrangling, C & F agreed in 2002 to drop its last remaining claim, trade secret misappropriation,

[656 F.3d 571]

in exchange for a $15.3 million payment from Pizza Hut. Closing the book on the long-running lawsuit merely opened a new chapter of legal difficulties for C & F and its shareholders, however. When it received its $6.12 million take-home portion of the settlement, C & F, an S corporation, reported the income to the Internal Revenue Service as long-term capital gain. Its shareholders reported their passed-through pro rata shares of the settlement the same way. The Commissioner of Internal Revenue concluded that the settlement income should have been taxed as ordinary income and issued each of the shareholders (and, in some cases, their jointly filing spouses, whom we will include among “the shareholders”) a deficiency notice. The shareholders challenged the determination in the tax court, which agreed with the Commissioner's treatment of the settlement income and ordered deficiency judgments. The shareholders now appeal. We affirm.I. Background

C & F is an Illinois-based meat processing company. In the early 1980s, 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. C & F treated as trade secrets all subsequent refinements to the process; we use the term “C & F process” to refer to the process and related trade secrets.

In 1985, one of C & F's long-time customers, Pizza Hut, expressed an interest in using sausage made pursuant to the C & F process in its outlets nationwide, which would result in purchases of at least 200,000 pounds per week. The catch was that C & F had to agree to share the C & F process with Pizza Hut's other sausage suppliers so that Pizza Hut could offer its customers a uniform product. Later that year, Pizza Hut and C & F signed an agreement pursuant to which C & F disclosed to Pizza Hut information relating to the C & F process, and Pizza Hut promised to keep mum about those details. C & F also entered into separate confidential licensing agreements with several of Pizza Hut's other suppliers, disclosing its C & F process in exchange for promises of confidentiality and licensing fees.

Pizza Hut faltered on its end of the bargain: it 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 whom 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. Pizza Hut bought less and less sausage from C & F, and C & F suffered financially. C & F eventually filed suit against both Pizza Hut and IBP in the Northern District of Illinois in 1993. In its second amended complaint, C & F alleged, inter alia, that Pizza Hut “misappropriated [its] trade secrets by, among other things: (a) acquiring the trade secrets through fraudulent misrepresentations and omissions, and (b) disclosing and using such trade secrets, after notice, without express or implied consent of C & F.” “As a result,” the complaint continued, “C & F has been damaged, and has suffered, among other things, lost profits, lost opportunities, operating losses, and expenditures.” C & F sought compensatory and punitive damages as well as injunctive relief and attorneys' fees in connection with its trade secret misappropriation claim.

The district court dismissed all the counts against Pizza Hut, including the claim of trade secret misappropriation. C & F's trade secret misappropriation claim against IBP proceeded to trial, however,

[656 F.3d 572]

and a jury awarded C & F $10.9 million in damages. The district court awarded C & F an additional $5 million in pre-judgment interest. Both C & F and IBP appealed to the Federal Circuit (one of the claims at issue was a patent claim involving the patent for the C & F process, which was ultimately invalidated). The Federal Circuit affirmed the jury's verdict on the IBP misappropriation claim, though it vacated the district court's interest award. IBP promptly paid C & F the $10.9 million judgment. C & F determined that it would have had approximately $2.86 million in additional profits if IBP had not misappropriated its trade secret; it treated that portion of its take-home from the settlement as ordinary income and the rest as capital gain on its 2000 federal income taxes. Its shareholders did the same and met no resistance from the Commissioner.

The Federal Circuit also decided that the district court had erred in dismissing C & F's trade secret misappropriation claim against Pizza Hut. It remanded that claim, the only surviving claim in the suit, back to the Northern District of Illinois. Pizza Hut moved for summary judgment, but became amenable to settlement after the district court denied that motion. Pizza Hut and C & F settled the trade secret misappropriation claim for $15.3 million in January 2002. The settlement agreement provided for “a lump-sum payment in full and complete discharge and settlement of the Lawsuit and all other past, present, and future claims that could be asserted now or in the future by the C & F Parties and Pizza Hut related to the events or circumstances described in the Lawsuit.” After deducting attorneys' fees, expenses, and a sizeable payment to a former shareholder (who redeemed his shares to C & F in exchange for an interest in the suit) from the settlement, C & F walked away with $6.12 million.

C & F characterized the $6.12 million as gain from a “trade secret sale” and reported the entire amount as long-term capital gain on its 2002 federal income tax form. The Schedule K–1s that C & F distributed to the shareholders characterized the settlement proceeds the same way. The shareholders in turn reported their proportionate shares of the settlement as long-term capital gain on their 2002 federal income taxes.

In March 2007, the Commissioner issued notices of deficiency to the shareholders after determining that the $6.12 million settlement was ordinary income, not long-term capital gain. The former is taxed at a higher rate than the latter; some shareholders were assessed deficiencies in excess of $700,000. The Commissioner also determined that the portion of the settlement C & F allocated to the former shareholder—some $3.06 million—should have been reported as income by C & F rather than deducted; the asserted deficiencies reflected this position. The shareholders challenged the deficiency assessments by timely filing petitions with the United States Tax Court. See 26 U.S.C. § 6213. Their cases were properly consolidated. After the claims proceeded to trial, the Commissioner conceded that C & F properly deducted the $3.06 million it paid to the former shareholder; the sole issue remaining for the tax court was whether the $6.12 million should have been reported as ordinary income or long-term capital gain.

At the one-day, single-witness trial and in the briefing that followed it, the shareholders raised three arguments in support of their position that the settlement proceeds should be taxed as long-term capital gain. First, relying on Inco Electroenergy Corp. v. Comm'r, T.C.M. (P–H) 1987–437, which held that moneys received for injury or damage to capital assets are taxable as capital gain, they argued that the settlement

[656 F.3d 573]

here was payment for damage to C & F's trade secrets, which are capital assets, see id.; Ofria v. Comm'r, 77 T.C. 524, 541–42 (1981). Second, recognizing that long-term capital gain is defined in terms of the “sale or exchange” of capital assets, see 26 U.S.C. § 1222(3), they asserted that the settlement payment represented the culmination of a “sale or exchange” of the trade secrets relating to the C & F process. Finally, looking to 26 U.S.C. § 1234A, which treats as capital gain income attributable to the termination of certain rights or obligations, they 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 rejected all three arguments and sustained the Commissioner's determination that the settlement proceeds should be taxed as ordinary income. (The deficiencies were recalculated and reduced to reflect the Commissioner's concession.) The shareholders reassert their first two arguments in this appeal, over which we have jurisdiction. 26 U.S.C. § 7482(a)(1).II. Discussion A. Standard of Review

We review decisions of the tax court “in the same manner and to the same extent as decisions of the district courts in civil actions tried without a jury.” Id.; see generally Thomas v. Gen. Motors Acceptance Corp., 288 F.3d 305, 307–08 (7th Cir.2002) (discussing standards of review in such cases). The parties agree that this means that we review conclusions of law de novo and findings of fact for clear error. See Cole v. Comm'r, 637 F.3d 767, 773 (7th Cir.2011). They part ways, however, when...