Lawsuit Award Allowed to Reduce Basis of Acquired Assets

The determination of the taxation of a litigation award was considered by the IRS in PLR 201152010.  In the matter at hand the taxpayer had been attempting to acquire a unit investment trust and had negotiated an agreement that tied down the purchase price.  The agreement was contingent on receiving unitholder approval of the purchase, which the taxpayer expected to receive.

Before such a vote took place, a third party interfered with the transaction and the taxpayer was therefore unable to obtain unitholder approval.    The taxpayer amended the agreement to acquire the target entity, now set at a higher price.  This time unitholder approval was obtained and the acquisition took place.

The taxpayer filed a lawsuit against the party that interfered with the transaction and was awarded damages in the amount of the price increase.   The question at this point was the tax treatment of the damage award.

The IRS held that the damage award represented a reduction of the basis of the investment acquired.  The IRS looked at the complaint, jury instructions, verdict and the opinion of the Trial Court judge, which consistently indicated that the defendant had tortuously interfered with the acquisition and increased the cost by the exact amount of the damages both requested and awarded.  As such the IRS found the payment “should be treated as a restoration of the $Z of additional capital that Taxpayer invested to complete the acquisition at the increased price.”

The IRS goes on to refer the Supreme Court’s 1952 decision in the case of Arrowsmith v. Commissioner, 344 U.S. 6 in which the Supreme Court found that shareholders who in a later year paid expenses of the corporation after a liquidation of a corporation had capital losses and not ordinary losses.  The ruling notes that this case holds that “when a subsequent event is so integrally related to a prior event that the events are in effect part of the same transaction, the tax consequences of the subsequent event should be determined by reference to the prior event.”  The IRS found the lawsuit in the matter before it was sufficiently intertwined with the acquisition that it was effectively part of the transaction.

Unfortunately in most cases the facts aren’t quite as clear cut as they were in this case.  Often it will take work to determine exactly what damages were received for if the taxpayer’s counsel advanced multiple theories regarding why damages should be paid.  However the process taken by IRS in this case would generally be followed in those cases as well—all relevant documents should be considered to determined if there exists a clear indication of the nature of the damages paid.

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