111 T.C. No. 13

UNITED STATES TAX COURT

BRIAN L. AND CAROLE J. NAHEY, Petitioners v

. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8497-96. Filed October 21, 1998.

W, a corporation, sued X for breach of contract and

misrepresentation for failing to complete the

installation of a computer system and sought damages for

lost profits. X counterclaimed for withheld payments by

W.

In 1986, P, through his two S corporations, acquired

all of the assets and assumed all of the liabilities of

W, including W's lawsuit against X and X's counterclaim

against W. W was thereafter liquidated. No part of the

purchase price for W's assets was allocated to the claim

against X.

In 1992, the lawsuit with X was settled for total

consideration of $6,345,183. The settlement proceeds

were paid to the S corporations and reported as long-term

capital gain that passed through to P. R determined that

the settlement proceeds constituted ordinary income. P

asserts that the lawsuit constituted a capital asset and- 2 -

1 In their petition contesting respondent's determination

that the settlement proceeds received by the S corporations (and

passed through to petitioners) constitute ordinary income,

petitioners asserted, as an alternative position, that the S

corporations should have reported the settlement proceeds as a

nontaxable return of capital. In their posttrial brief,

petitioners abandoned this alternative argument. that the settlement of the lawsuit constituted a sale or

exchange for purposes of the capital gain pr ovisions.

H eld : The settlement of the lawsuit between the S

corporations and X did not constitute a sale or exchange

pursuant to sec. 1222, I.R.C., and thus the settlement

proceeds r eceived by the S corporations and passed

through to P constitute ordinary income.

Robert A. Schnur and Joseph A. Pickart , for petitioners.

George W. Bezold and Christa A. Gruber , for respondent.

JACOBS, Judge : Respondent determined a $185,833 deficiency in

petitioners' 1992 Federal income taxes.

The deficiency herein arises fro m the parties' dispute over

the characterization of settlement proceeds from a lawsuit that was

brought by a corporation whose assets, including the lawsuit, were

purchased by petitioners' two S corporations. The sole issue we

must decide is whether the settlement proceeds received by the S

corporations (and passed through to petitioners) constitute

ordinary income, as respondent contends, or long-term capital gain,

as petitioners contend. 1

All section references are to the Internal Revenue Code as in

effect for the year in issue.- 3 -

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The

stipulated facts are incorporated in our findings by this

reference.

At the time the petition was filed, petitioners Brian L. and

Carole J. Nahey, husband and wife, resided in Hartland, Wisconsin.

(All references to petitioner in the singular are to Mr. Nahey.)

Wehr Corporation

Wehr Corporation (Wehr), a Wisconsin corporation, manufactured

and distributed a variety of industrial equipment and devices, such

as air distribution equipment, high-technology electronics, motor

brakes, clutches, and refractory brick presses.

From the mid-1970's until the end of 1986, petitioner held the

positions of president, chief executive officer, and member of the

board of directors of Wehr.

At the end of 1986, petitioner owned approximately 10 percent

of the stock of Wehr, Bruce A. Beda (who is not described i n the

record) owned an additional 3 percent, and the balance of the stock

was owned by members of the Manegold family directly or through

trusts established for their benefit.

The Xerox Lawsuit

On December 31, 1983, Wehr contracted with Xerox Corporation

(Xerox) to implement and install a fully integrated on-line, closed

loop computer system to unite all of Wehr 's operational,- 4 -

managerial, and administrative function s in a real-time manner.

Upon installation, this system would have given Wehr a competitive

edge in its marketplace, increasing its revenues and profits.

Pursuant to the terms of the contract, which were negotiated

by petitioner on behalf of Wehr, Xerox agreed to complete the

project by December 31, 1984. During the period in which Xerox was

to implement and install the new system, Xerox allowed Wehr to run

its (Wehr's) information services systems on Xerox's computers in

California on a fee-for-service basis of approximately $70,000 per

month.

From the inception of the project, Xerox fell behind schedule

and missed target dates. Wehr responded to Xerox's missed target

dates by withholding payment of the monthly fee for using Xerox's

computer services in California . In January 1985, at which time

Wehr estimated that only 1 to 2 percent of the required services

had been performed, Xerox warned Wehr that its continued failure to

pay would result in the termination of all services. Nonetheless,

Wehr still refused to pay, and Xerox terminated all services. At

that time, Wehr allegedly owed $652,984.33 to Xerox.

On February 11, 1985, Wehr filed a lawsuit against Xerox in

the United States District Court fo r the Eastern District of

Wisconsin, alleging breach of co n tract, intentional fraud and

misrepresentation, and negligent misrepresentation. Although no

specific amount of damages was stated, the complaint alleged that- 5 -

such damages exceeded $5 mi llion. In its answer to the lawsuit,

Xerox asserted a counterclaim that Wehr wrongfully withheld

payments to Xerox and demanded damages in the amount not yet paid.

Sometime in 1986 while discovery proceeded, a newly appointed

Xerox division pres ident visited petitioner in Milwaukee and

proposed to settle Wehr's claim for $1.2 mil lion, although he

indicated he could go as high as $2 million. This offer was

rejected by petitioner.

Throughout the course of the litigation, petitione r, in his

capacity as chief executive officer at Wehr, kept the board of

directors and Mr. Manegold (who was chairman of the board) informed

about the lawsuit as well as the proposed settlement and its

rejection. Petitioner also informed Mr. Manegold that he believed

Wehr could recover as much as $10 million from Xerox.

Petitioner's Acquisition of Wehr

During the fall of 1986, Mr. Manegold contacted petitioner and

inquired whether he was interested in purchasing Wehr's assets.

(Apparently, Mr. Manegold anticipated forthcoming changes in the

tax laws that made it advantageous for him and his family to sell

Wehr prior to the end of 1986.) Mr. Manegold's asking price was in

excess of $100 million, which required petitioner to seek

financing.

Petitioner spoke with investment banks about assisting in the

purchase of Wehr. The investment banks offered to finance the- 6 -

ac q uisition in exchange for control of Wehr--which petitioner

opposed. Throughout the discussions with the investment banks,

petitioner informed the bankers of the pending lawsuit because of

its impact on c ash-flows; the lawsuit also appeared in Wehr's

financial reports. Petitioner believed Wehr would receive between

$2 million and $10 million from the lawsuit against Xerox.

Ultimately, petitioner proposed that Mr. Manegold finance the

deal as part of a leveraged buy out (in which pet itioner would

pledge his shares and use the cash-flows from the corporation to

repay the debt and interest). In evaluating the financing

possibilities, petitioner analyzed Wehr's cash-flow potential, and

included the lawsuit against Xerox in that analysis. Mr. Manegold

based the $100 million asking price on a multiple of earnings

analysis.

On December 30, 1986, petitioner and Mr. Manegold reached an

agreement for the acquisition of Wehr. Petitioner organized two S

corporations (hereinafter referred together as the S corporations),

Venturedyne, Ltd. (Venturedyne), and Carnes Company, Inc. (Carnes),

for the purpose of acquiring Wehr. Pursuant to the acquisition

agreement, Venturedyne purchased all the assets and assumed all the

liabilities of Wehr, other than those related to the Carnes

division of Wehr. All the assets and liabilities of the Carnes

division of Wehr were acquired and assumed by Carnes. Through

1992, petitioner owned 97.624190 percent of each of the S- 7 -

corporations, and the remainder was owned by Mr. Beda. Since the

inception of Venturedyne and Carnes, petitioner has served as the

chairman of the board of directors, president, and chief executive

officer of both entities.

Following the purchase of Wehr's assets and the assumption of

Wehr's liabilities by the S corporations, Wehr was liquidated. The

S corporations continued to operate the same businesses as operated

by Wehr prior to its liquidation.

Among the assets ac quired by the S corporations were all

lawsuits brought by Wehr, including the claim against Xerox. The

liabilities assumed by the S corporations included all lawsuits

brought against Wehr, including Xerox's counterclaim. Because the

parties to the buy out of Wehr did not allocate the purchase price

to specific assets, the S corporations engaged two accounting firms

to assist in that process. The accounting firms attempted to

determine a value for the Xerox lawsuit, but no value was assigned

to Wehr's claim against Xerox because the accountants determined

that the value of such claim was "t oo speculative". Thus, no

portion of the purchase price for Wehr's assets was allocated to

the Xerox lawsuit, and neither of the S corporations booked the

lawsuit as an asset. (However, a footnote in the S corporations'

audited financial statements identified the existence of the claim

against Xerox.) In a Closing Agreement On Final Determination

Covering Specific Matters between the S corporations, petitioners,- 8 -

Mr. Beda, and the Commissioner, executed on July 1, 1993, no

portion of the purchase price was allocated to the Xerox lawsuit.

The Xerox Lawsuit: Post-1986

Following the buy out of Wehr, the S corporations c ontinued

the lawsuit against Xerox in Wehr's name. The primary disagreement

of the parties to that lawsuit during the post-19 86 period

concerned the nature and extent of the damages caused by Xerox's

failure to complete the implementation and instal lation of the

computer system. The parties fought over: (1) Whether Xerox could

examine the S corporations' audited finan c ial statements with

respect to the issue of lost profits (even though the damages were

alleged only with respect to Wehr); (2) whether Wehr could continue

to pursue noncontract claims under the so-called economic loss

doctrine; (3) whether Wehr had a duty to mitigate damages following

the termina tion of services by Xerox, and if so, when would the

compute r system project have been completed if it had been

continued by Xerox or another party; and (4) whether Wehr could

introduce a new method of calculating damages that produced figures

ranging from $20 million to more than $120 million in damages.

In late 1992, the District Court ruled that Wehr could

introduce evidence as to the new method of calculating damages at

trial; immediately thereafter, Xerox sought to settle the lawsuit.

Initially, Xerox offered between $2 mill ion and $3 million, but

petitioner responded that he would not accept less than $10- 9 -

million. Xerox indicated that it would go no higher than $6

m illion, and petitioner's counsel, who believed that Xerox's

mitigation argument was a strong one, advised petitioner to accept

that amount. The parties eventually agreed to a settlement by

which Xerox would pay $5,950,000 in cash and cancel the $395,183

debt owed by Wehr (and assumed by the S corporations) to Xerox, for

a total of $6,345,183. The lawsuit was then dismissed with

pre judice. The cash payment was made by Xerox on or before

December 31, 1992.

Reporting of the Settlement

The S corporations allocated th e settlement with Xerox as

follows: $3,502,541 to Venturedyne; $2,84 2,183 to Carnes. The S

corporations each reported the settlement as long-term capital gain

on their respective 1992 corporate income tax returns. Petitioners

similarly reported their allocable share of the settlement

($6,194,437) as long-term capital gain on their 1992 joint income

tax return. In calculating the capital gain, neither the S

corporations nor petitioners attributed any basis to the lawsuit.

In the notice of deficiency, respondent determin ed that the

settlement proceeds should have been reported as ordinary income.

OPINION

The s ole issue for decision herein is whether the proceeds

receive d by the S corporations from the settlement of Wehr's

lawsuit against Xerox (the settlement pro ceeds) should be- 10 -

characterized as ordinary i ncome or long-term capital gain. The

resolution of this issue turns on whether the requirements for

obtaining capital gain treatment are satisfied, including whether

the settlement of Wehr's lawsuit against Xerox constitutes a "sale

or exchange".

The parties center their arguments on the "origin of the

claim" test to determine whether the settlement proceeds should be

characterize d as capital gain or ordinary income. See U nited

States v. Hilton Hotels Corp.

, 397 U.S. 580 (1970); Woodward v.

Commissioner

, 397 U.S . 572 (1970); U nited States v. Gilmore

, 372

U.S. 39 (1963); Gidwitz Family Trust v. Commissioner

, 61 T.C. 664,

673 (1974); Keller Street Dev. Co. v. Commissioner

, T.C. Memo.

1978-350, affd. 688 F.2d 675 (9th Cir. 1982). We, however, shall

focus our att ention on whether the settlement of the lawsuit

constitutes a sale or exchange.

A sale or exchange is a prerequisite to the rendering of

capital gain treatment. Sec. 1222; Estate of Nordquist v.

Commissioner

, 481 F.2d 1058, 1061 (8th Cir. 1973), affg. T.C. Memo.

1 972-198; Ackerman v. United States

, 335 F.2d 521, 526-52 7 (5th

Cir. 1964); Breen v. Commissioner

, 328 F.2d 58, 64 (8th Cir. 1964),

affg. T.C. Memo. 1962-230. The phrase "sale or exchange" is not

defined in section 1222, but we apply the ordinary meaning to those

words. H elvering v. William Flaccus Oak Leather Co.

, 313 U.S. 247,

249 (1941).- 11 -

It is well established that a compromise or collection of a

debt is not considered a sale or exchange of property because no

property or property rights passes to the debtor other than the

discharge of the obligation. See Fairbanks v. United States , 306

U.S . 436 (1939); N ational-Standard Co. v. Commissioner

, 749 F.2d

369 (6th Cir. 1984), affg. 80 T.C. 551 (1983); Osenbach v.

Commissioner

, 198 F.2d 235 (4th Cir. 1952), affg. 17 T.C. 797

(1951); Lee v. Commissioner

, 119 F.2d 946 (7th Cir. 1941), affg. 42

B.T.A. 920 (1940); Guthrie v. Commissioner , 42 B.T.A. 696 (1940);

Hale v. Commissioner

, 32 B.T.A. 356 (1935), affd. sub nom. Hale v.

Helvering

, 85 F.2d 819 (D.C. Cir. 1936). In this regard, whatever

property or property rights might have existed vanish as a result

of the compromise or collection. L eh v. Commissioner

, 27 T.C. 892,

898 (1957), affd. 260 F.2d 489 (9th Cir. 1958).

On several occasions we have addressed the issue of whether a

sale o r exchange occurred on the payment of a judgment or the

settlement of a claim. See T owers v. Commissioner , 24 T.C. 199

(1955), affd. 247 F.2d 233 (2d Cir. 1957); Hudson v. Commissioner

,

20 T.C. 734 (1953), affd. per curiam sub nom. Ogilvie v.

Commissioner

, 216 F.2d 748 (6th Cir. 1954); Fahey v. Commissioner

,

16 T.C. 105 (1951). In F ahey v. Commissioner

, supra

, we held that

where an attorney was assigned an interest in a contingent lawsuit

fee in exchange for a cash payment, settlement of the lawsuit and

payment of the fee to the attorney did not give rise to capital- 12 -

2 Our reasoning in Fahey v. Commissioner , 16 T.C. 105

(1951), was followed by the Court of Appeals for the Fifth

Circuit in Pounds v. United States , 372 F.2d 342, 349 (5th Cir.

1967), a case relied on by petitioners in support of their

argument that the Xerox lawsuit was a capital asset. The Pounds

court found that no sale or exchange occurred on the payment of a

12-1/2 percent profit interest in a land deal because following

the transaction only one party, the taxpayer, received property

(the cash payment). gain treatment because no sale or exchange occurred. In reaching

our conclusion, we quoted from the opinion of the Court of Appeals

for the District of Columbia in Hale v. Helvering

, supra (relating

to the compromise of a note for less than face value):

There was no acquisition of pro perty by the debtor, no

transfer of proper ty to him. Neither business men nor

lawyers call the compromise of a note a sale to the

maker. In point of law and in legal parlance property in

the notes as capital assets was extinguished, not sold.

In business parlance the transaction was a settlement and

the notes were turned over to the maker, not sold to him.

* * *

Fahey v. Commissioner

, supra at 109. 2

In Hudson v. Commissioner

, supra , the taxpayers purchased a

50-percent interest in a judgment from the legatees of an estate,

and subsequently the taxpayers set tled the judgment with the

debtor. The taxpayers reported the payment of the judgment as

capital gain. We held that the payment should be characterized as

ordinary income, explaining:

We cannot see how there was a transfer of property,

or how the judgment debtor acquired property as the

result of the transaction wherein the judgme nt was

settled. The most that can be said is that the judgment

debtor paid a debt or extinguished a claim so as to

preclude the execution on the judgment outstanding- 13 -

3 The Court of Appeals for the Seventh Circuit, the court

to which an appeal in this case lies, has distinguished sales or

exchanges from collections and other transactions in which no

property or property rights survive. See Chamberlin v.

Commissioner , 286 F.2d 850, 852 (7th Cir. 1960), affg. 32 T.C.

1098 (1959); Lee v. Commissioner , 119 F.2d 946, 948 (7th Cir.

1941), affg. 42 B.T.A. 920 (1940). against him. In a hypothetical case, if the judgment had

been transferred to someone o t her than the judgment

d ebtor, the property transferred would still be in

existence after the transaction was completed. However,

as it actually happened, when the judgment debtor settled

the judgment, the claim arising from the jud gment was

extinguished wi thout the transfer of any property or

property right to the judgment debtor. In their day-today transactions, neither businessmen nor lawyers would

call the settlement of a judgment a sale; we can see no

reason to apply a strained interpretation to the

transaction before us. When petitioners received the

$21,150 in full settlement of the judgment, they did not

recover the money as a result of any sale or exchange but

only as a collection or settlement of the judgment.

Id. at 736.

Despite these and other similar cases 3

, petitioners contend

that the passing of property or property rights to the debtor is

not relevant in determining whether a sal e or exchange occurred.

In support of this argument, petitioners direct us to Commissioner

v. Ferrer

, 304 F.2d 125 (2d Cir. 1962), revg. in part and remanding

35 T.C. 617 (1961). In Ferrer , the taxpayer acquired from an

author the right to produce a play (based on the autho r's book)

which included the right to prevent the author's transfer of film

rights. Subsequently, the taxpayer surrendered his rights (the

"lease") in exchange for the leading role in a film production.

The issue arose as to whether the surrendering of the taxpayer's- 14 -

rights constituted a sale or exchange for purposes of the capital

gain provisions. In holding that a sale or exchange of the

surrendered lease occurred, the Court of Appeals for the Second

Circuit stated that Congress was disenchanted with the "formalistic

distinction" between a sale of property rights to third parties

(which would give rise to capital gain or loss) and the release of

those rights that results in their extinguishment (and which would

not give rise to capital gain or loss). The court continued:

In the instant case we can see no sensible business basis

for drawing a line between a release of Ferrer's rights

* * * and a sale of them * * *. * * * Tax law is

concerned with the substance, here the voluntary passing

of "property" rights allegedly constituting "capital

assets," not with whether they are passed to a stranger

or to a person already having a larger "estate." * * *

Id. at 131.

Petitioners have misread Ferrer and its import. Ferrer (and

the cases cited therein) can be factual ly distinguished from the

instant case because in Ferrer the taxpayer's interest (or lease)

to produce the play and prevent the author's transfer of film

rights did not disappear but instead reverted to the author after

the taxpayer su rrendered the lease; whereas in the instant case,

the S corporations' rights in the lawsuit vanished both in form and

substance upon the receipt of the settlement proceeds.

In the case herein, the S corporations and Xerox settled the

lawsuit originally brought by Wehr. The S corporations received

consideration of $6,345,183; Xerox received nothing other than the- 15 -

discharge of the liability that arose as the result of the lawsuit.

We find no discernible distinction between the situation herein and

the situations discussed in Fahey v. Commissioner

, supra

, or Hudson

v. Commissioner

, supra . In each case, the debtor made payment to

the creditor or an assignee of the original creditor in exchange

for the extinguishment of the claim. Whether the claim is reduced

to judgment before payment is not relevant; ultimately the debtor

receives nothing in the form of property or property rights which

can later be transferred. Consequently, we hold that the

settlement of the lawsuit between the S corporations and Xerox does

not constitute a sale or exchange and hence capital gain treatment

is not warranted.

Petitioners argue that the so-called Arrowsmith doctrine

requires us to apply capital gain treatment to the settlement claim

regardless of whether a sale or exchange occurred. We disagree.

In Arrowsmith v. Commissioner

, 344 U.S. 6 (1952), the Supreme Court

held that the characterization of a transaction may require

examination of prior, related transactions. In A rrowsmith

, the

taxpayer-shareholders reported as capital gain the gain realized on

the liquidation of their corporation. Subsequently, a judgment was

rendered against the former corporation, and the shareholders, as

transferees o f the corporation's assets, paid the judgment. The

Supreme Court held that the payment of the judgment resulted in a

capital (rather than ordinary) loss because the judgm ent was- 16 -

inextricably related to the capital gain which resulted from the

liquidation.

Here , petitioners assert that the receipt of the settlement

proceeds is related to a prior transaction, namely the acquisition

of Wehr's assets, citing B resler v. Commissioner

, 65 T.C. 18 2

(1975). In B resler

, the shareholder of an S corporation sought to

treat the proceeds from the settlement of an antitrust lawsuit as

cap ital gain, asserting that the settlement was intended to

compensate the taxpayer for losses that resulted from the earlier

sale of certain properties. We rejected that argument because the

earlier sale of the properties resulted in ordinary losses under

section 1231, and thus under Arrowsmith v. Commissioner

, supra

, the

settlement proceeds constituted ordinary income.

Petitioners have misapplied the rationale of Arro wsmith and

its progeny, including Bresler , to the situation herein. The

acquisition of Wehr's assets was not the basis for the lawsuit

against Xerox, and the settlement in favor of the S corporations

was not related to the leveraged buy out. Cf. W est v.

Commissioner

, 37 T.C. 684, 687 (1962). The origin of the claim in

this case was Xerox's breach of contract, as detailed in the

complaint filed by Wehr in the Dist rict Court. The treatment of

the settlement proceeds as ordinary income or capital gain is not

dependent on the fact that the S corporations acquired Wehr's- 17 -

4 As stated in Fahey v. Commissioner , 16 T.C. at 108, and

reiterated in Pounds v. United States , 372 F.2d at 349, the mere

occurrence of a sale or exchange of the subject asset at some

point in time is not sufficient to obtain capital gain treatment

on a later disposition. The sale or exchange must be proximate

to the event which gave rise to the gain. assets in a capital transaction. 4 As such, the A rrowsmith doctrine

is inapplicable.

We have considered al l of petitioners' other arguments and

find them to be not relevant or without merit.

In conclu sion, we hold that the settlement of the Xerox

lawsuit did not constitute a sale or exchange ; consequently, the

settlement proceeds constitute ordinary income, not capital gain,

to petitioners. Inasmuch as petitioners allocated no part of the

purchase price for Wehr's assets to the Xerox lawsuit, they

acquired no basis in the lawsuit. Thus, the entire settlement

proceeds are includable in gross income.

To reflect the foregoing,

Decision will be entered

for respondent

.