t c memo united_states tax_court joseph a and judith freda et al petitioners v commissioner of internal revenue respondent docket nos filed date jenny l johnson and ziemowit t smulkowski for petition- ers john j comeau and kathleen c schlenzig for respondent 1cases of the following petitioners are consolidated here- with mark n freda docket no joseph m and victoria a freda docket no michael f maude jr and maria e maude docket no michael r and kathryn a newcome docket no dennis j and mary ann olson docket no matthew j olson docket no michael and lynn slaboch olson docket no and michael p and christine stock docket no memorandum findings_of_fact and opinion chiechi judge respondent determined for taxable_year deficiencies in federal_income_tax tax as follows petitioner s joseph a and judith freda mark n freda joseph m and victoria a freda michael f maude jr and maria e maude michael r and kathryn a newcome dennis j and mary ann olson matthew j olson michael and lynn slaboch olson michael p and christine stock deficiency dollar_figure big_number big_number big_number big_number big_number big_number big_number the issue remaining for decision for taxable_year is whether the amount that pizza hut inc pizza hut paid to c f packing co inc c f during in settlement of certain claims of c f against pizza hut is long-term_capital_gain or ordinary_income to c f we hold that that amount is ordinary_income findings_of_fact some of the facts have been stipulated and are so found at the time petitioners except mark n freda filed their respective petitions they resided in illinois at the time petitioner mark n freda filed his petition he resided in washington 2as discussed below for taxable_year c f was an s_corporation the income of which flowed through to its stockhold- ers certain petitioners herein stockholder petitioners at all relevant times including during petitioners joseph a freda mark n freda joseph m freda maria e maude kathryn a newcome mary ann olson matthew j olson michael olson and christine stock were stockholders of c f at all relevant times c f a corporation organized in illinois that maintained its principal_place_of_business in that state made and sold a variety of meats including sausage at those times c f was an s_corporation since the early 1970s c f supplied uncooked sausage to pizza vendors including pizza hut in after several years of work c f succeeded in developing a process c f process for making precooked sausage that had the appearance and taste of home-cooked sausage in c f applied for and later ob- tained a patent c f process patent on the c f process thereafter c f continued to improve the c f process c f treated as a trade secret c f trade secret the information relating to the c f process and the improvements made to that process after obtaining the c f process patent 3petitioners judith freda victoria a freda michael f maude jr michael r newcome dennis j olson lynn slaboch olson and michael p stock are petitioners in their respective cases solely because each filed a joint tax_return with his or her spouse who was a stockholder of c f during 4c f also obtained a separate patent on an apparatus that was specially designed for use in the c f process around pizza hut expressed an interest in using nationwide sausage made with the c f process on date certain executives of pizza hut pizza hut executives and certain executives of c f c f executives met to discuss pizza hut’s interest in the c f process date meeting during that meeting the pizza hut executives informed the c f executives that pizza hut was willing to enter into a contract with c f under which pizza hut was to purchase from c f sausage made using the c f process only if c f was willing to share the c f process with other pizza hut suppliers during the date meeting the c f executives countered that c f was willing to share the c f process with other pizza hut suppliers only if c f was to receive a royalty on all sales of sausage made with that process the pizza hut executives rejected that counterpro- posal with an offer that pizza hut and c f enter into a long-term supply contract under which pizza hut was to purchase from c f one-half of its total sausage needs with a guaranteed floor of at least big_number pounds of sausage per week during the date meeting the pizza hut executives also insisted that any such supply contract between pizza hut and c f include an agree- ment by c f not to license the c f process or to sell sausage made with that process to certain major competitors of pizza hut on date pizza hut and c f executed a document entitled confidential disclosure agreement pizza hut confiden- tiality agreement that document required inter alia c f to disclose to pizza hut confidential information relating to the meat product process and apparatus invention as we c f believe will be required to enable you pizza hut to evaluate the same the pizza hut confidentiality agreement further required inter alia pizza hut to keep confidential the information that c f disclosed to pizza hut not to disclose that information to any person not employed by pizza hut without the written consent of c f and not to use that information for the benefit of any person or entity except pizza hut without the written consent of c f pursuant to the pizza hut confidentiality agreement c f disclosed to pizza hut the c f process and all improvements made to that process after c f obtained the c f process patent around late c f also entered into certain agreements third-party confidentiality agreements with the following four suppliers of pizza hut pizza hut’s third-party suppliers h m food systems co standard meat co doskocil cos inc and parks sausage each of those agreements required c f to disclose confidential information relating to the meat product process and apparatus invention as c and f believes will be required to enable pizza hut’s third-party supplier to operate the same and to make patented and know-how product pursuant to the third-party confidentiality agreements pizza hut’s third-party suppliers were to maintain confidentiality with respect to the information that c f disclosed to them and not to dis- close that information to or use it for the benefit of anyone else without the written consent of c f pursuant to the third-party confidentiality agreements c f shared the c f trade secret with pizza hut’s third-party suppli- ers by at least early all of those suppliers had dupli- cated the c f process and were selling sausage made with that process to pizza hut thereafter pizza hut extracted from c f certain price reductions for the sausage that it was purchasing from c f and pressured c f into incurring substantial expendi- tures on its behalf in reliance on the discussions at the date meeting and the prospect of a significant supply con- tract with pizza hut c f purchased and refurbished at substantial cost a new production facility incurred the cost of correcting the deficiencies in certain substandard products that other companies produced for pizza hut and incurred the cost of operating a c f production facility to assist pizza hut in the development of new products such as a bacon pizza top- ping although c f undertook certain actions in reliance on the discussions at the date meeting including those de- scribed above pizza hut did not enter into a long-term supply contract with c f as the pizza hut executives had promised to do at that meeting nor did pizza hut’s weekly purchases of sausage from c f after the date meeting through early reach big_number pounds as those executives had also promised at that meeting starting around when ibp inc ibp was one of pizza hut’s largest suppliers of meat products other than sausage pizza hut disclosed the c f trade secret to that company without having informed c f or acquired its consent thereafter ibp replicated the c f process and began to sell to pizza hut sausage made with that process and pizza hut began to buy less sausage from c f around late or early c f began to suspect that ibp was using the c f process in early c f confirmed its suspicions when ibp allowed c f’s attorneys to inspect ibp’s manufacturing_facility on date c f filed a complaint against ibp in the u s district_court for the northern district of illinois dis- trict court in which it alleged that ibp had infringed the c f process patent we shall refer to the proceeding that c f initiated in the district_court as the c f lawsuit on the same date c f sent pizza hut a letter in which it informed pizza hut about the c f lawsuit shortly thereafter pizza hut stopped purchasing sausage from c f and terminated c f as a supplier on date c f amended its complaint in the c f lawsuit and added a claim against pizza hut for inducement of patent in- fringement on date c f filed a second amended complaint in the c f lawsuit second amended complaint in that complaint c f alleged fraud against pizza hut pizza hut fraud count breach of fiduciary duty against pizza hut pizza hut breach of fiduciary duty count unfair competition against pizza hut pizza hut unfair competition count unjust enrichment against pizza hut pizza hut unjust enrichment count patent infringement against both pizza hut and ibp pizza hut and ibp patent infringement count tortious interference with business expectancy against ibp ibp tortious interference count unfair competition against ibp ibp unfair competi- tion count and misappropriation of trade secrets against pizza hut in violation of the illinois trade secrets act pizza hut misappropriation count as part of the pizza hut misappro- priation count c f alleged c f restates paragraph sec_1 through of count i as paragraph sec_1 through of count viii the confidential information which c f en- trusted to pizza hut included trade secrets protected by the illinois trade secrets act ilcs et seq pizza hut misappropriated such trade secrets by among other things a acquiring the trade se- crets through fraudulent misrepresentations and omis- sions and b disclosing and using such trade secrets after notice without express or implied consent of c f as a result c f has been damaged and has suffered among other things lost profits lost oppor- tunities operating losses and expenditures pizza hut’s misappropriation was willful and malicious prayer for relief wherefore c f asks this court to enter judgment against pizza hut for the following relief a b c d e an award of compensatory_damages in an amount to be determined at trial an award of punitive_damages in an amount to be determined at trial an injunction prohibiting pizza hut’s future use and disclosure of c f’s trade secrets an award of c f’s reasonable attorney’s fees and such other and further relief as this court and or jury may deem proper and just in a memorandum opinion and order filed on date date opinion and order the district_court granted pizza hut’s motion to dismiss the following counts in the second amended complaint the pizza hut fraud count the pizza hut breach of fiduciary duty count the pizza hut unfair competition 5paragraph nos and in the pizza hut misappropriation count are also used in the pizza hut breach of fiduciary duty count any reference hereinafter to paragraph or of the second amended complaint is to the paragraph number in the pizza hut misappropriation count count the pizza hut unjust enrichment count and the pizza hut misappropriation count on date pursuant to a document entitled shareholder redemption agreement redemption agreement c f redeemed the c f stock held by gerald freda redeemed stock- holder the redemption agreement provided that the redeemed stockholder was to tender to c f all of his c f stock in exchange for certain consideration that c f was to provide to him includ- ing a one-third interest in the c f lawsuit in a report and recommendation filed on date date report a u s magistrate judge of the district_court magistrate judge recommended that that court grant ibp’s motion for summary_judgment with respect to the ibp tortious interference count and the ibp unfair competition count in the date report the magistrate judge also recommended that the district_court deny ibp’s motion for summary_judgment with respect to a claim against ibp for misappropriation of trade secrets ibp misappropriation count on a date not disclosed by the record the district_court accepted the magistrate judge’s recommendations and dismissed the ibp tortious interference count and the ibp unfair competition count and denied ibp’s motion for summary_judgment with respect to the ibp misappropriation count in an opinion filed on date the district_court held that the c f process patent was invalid as a result that court granted the respective motions for summary_judgment that ibp and pizza hut had filed with respect to the pizza hut and ibp patent infringement count in date the district_court conducted a jury trial with respect to the ibp misappropriation count on date the jury returned a verdict in favor of c f on that count and awarded it dollar_figure in damages based on a theory of unjust enrichment thereafter the district_court awarded to c f prejudgment_interest on the jury’s damages award and denied ibp’s posttrial motions for a judgment as a matter of law b a new trial and c remittitur posttrial motions ibp appealed the district court’s judgment awarding c f prejudgment_interest and denying its posttrial motions c f appealed the district court’s judgment reflecting its date opinion and order dismissing the pizza hut fraud count the pizza hut breach of fiduciary duty count the pizza hut unfair competition count the pizza hut unjust enrichment count and the pizza hut misappropriation count in an opinion filed on date court_of_appeals opinion the u s court_of_appeals_for_the_federal_circuit court_of_appeals affirmed the district court’s denial of ibp’s posttrial motions and affirmed that court’s award of dollar_figure in damages with respect to the ibp misappropriation count the court_of_appeals also affirmed the district court’s dismissal of the pizza hut fraud count the pizza hut breach of fiduciary duty count the pizza hut unfair competition count and the pizza hut unjust enrichment count however the court_of_appeals reversed the district court’s award of prejudgment_interest to c f the court_of_appeals also reversed the district court’s dismissal of the pizza hut misappropriation count reinstated that count and remanded the case to the district_court for further proceedings after the court_of_appeals opinion the only unsettled claim in the c f lawsuit was the pizza hut misappropriation count at a time during after the court_of_appeals affirmed the district court’s award with respect to the ibp misappropria- tion count ibp paid to c f dollar_figure ibp payment which equaled the damages that the district_court awarded to c f consistent with the jury’s verdict on the ibp misappropriation count of that dollar_figure c f paid dollar_figure to its attorneys niro scavone haller niro niro law firm paid dollar_figure or one-third of the balance after its payment to the niro law firm to the redeemed stockholder and retained dollar_figure or two-thirds of the balance after its payment to the niro law firm at a time not disclosed by the record after date and before date pizza hut filed a motion for summary_judgment with respect to the pizza hut misappropriation count in a memorandum opinion and order filed on date the district_court denied that motion on date c f petitioner joseph a freda petitioner dennis j olson the redeemed stockholder and pizza hut entered into an agreement entitled settlement agreement and release settlement agreement that agreement provided in pertinent part 6c f filed form_1120s u s income_tax return for an s_corporation form_1120s for taxable_year s corpora- tion return in that return c f reported the following with respect to the ibp payment dollar_figure as net sec_1231 gain loss and dollar_figure as net gain loss from form_4797 part ii line c f included with the s corpora- tion return form_4797 sales of business property in form_4797 part i sales or exchanges of property used in a trade or busi- ness and involuntary_conversions from other than casualty or theft - most property held more than year c f reported dollar_figure as a gain from a trade secret sale in that part of that form c f also reported dollar_figure as a loss from the sale of machinery equipment resulting in a net gain of dollar_figure in form_4797 part ii ordinary gains and losses c f reported dollar_figure as a gain from a lost profit settlement 7we shall refer collectively to c f petitioner joseph a freda petitioner dennis j olson and the redeemed stockholder all of whom entered into the settlement agreement with pizza hut as the c f parties i recital sec_1 c f has asserted claims against pizza hut for damages as set forth in an amended complaint second amended complaint and subsequent pleadings filed in the action entitled c f packing co inc v pizza hut inc no c united_states district_court for the northern district of illinois hereinafter referred to as the lawsuit the c f parties and pizza hut desire to enter into this agreement in order to provide 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 and circumstances described in the lawsuit upon the terms and conditions set forth herein without the necessity of proceeding with a trial on the merits and all without admission of liability or wrongdoing on the part of pizza hut ii payment in consideration of the dismissal with prejudice of the lawsuit and the release representations warranties and the remaining promises set forth in this agreement pizza hut agrees to make a cash payment in the amount of dollar_figure fifteen million three hundred thousand dollars and zero cents payable to c f packing co inc and its attorneys niro scavone haller niro on or before date by wire transfer iii agreements respecting present and future claims and causes of action in consideration of the above payment and release and dismissal the parties agree to the following dismissal with prejudice within two days of receipt of the payment required by this agree- ment c f’s attorneys shall file with the court an agreed-to order dismissing the lawsuit with prejudice in the form attached hereto as exhibit a release the c f parties and pizza hut mutually release and forever discharge one another their predecessors and successors in interest assign- ees nominees and their past present and future parents subsidiaries affiliates divisions officers directors employees stockholders attorneys ser- vants representatives partners and agents as well as all of the subsidiaries divisions affiliates direc- tors officers agents employees attorneys heirs executors administrators and assignees of all those persons and entities hereinafter all collectively referred to as the released parties of and from any and all past present or future claims obligations actions or causes of action however denominated for any injury damage or loss arising directly or indi- rectly from pizza hut’s relationship with c f as a pizza hut product supplier including but not in any sense limited to all claims and allegations that were or that could have been asserted in the lawsuit the c f parties and pizza hut intend for the released parties that are not parties to this agreement to be third-party beneficiaries of the release provided for by this paragraph covenant not to sue the c f parties and pizza hut agree not to at any time sue institute or assist in instituting a proceeding in any court or forum alleging any claim that is covered by the re- lease in paragraph of this agreement the c f parties and pizza hut acknowledge that the payment called for by this agreement is being made to compromise and settle claims disputed as to both liability and amount and is being made to c f in settlement and release of all past present and or future claims against any of the pizza hut released parties neither payment of the sum reflected herein nor any statements or communications made by pizza hut or its agents during the negotiations leading to this agreement shall be considered admissions of liability by or on behalf of any of them the c f parties and pizza hut acknowledge that this agreement is intended to terminate any claims by them against the released parties and to bar any future litigation between the parties hereto and that there is no agreement by pizza hut to make any payment or to do any act or thing other than as expressly stated herein pursuant to section ii of the settlement agreement pizza hut issued a check for dollar_figure pizza hut payment that was payable to c f and the niro law firm and sent that check to that firm the niro law firm retained dollar_figure of the pizza hut payment as legal fees and expenses and distributed on febru- ary a one-third of the balance or dollar_figure to the redeemed stockholder and b two-thirds of the balance or dollar_figure to c f c f filed form_1120s for taxable_year s corpora- tion return in that return c f reported a net_long-term_capital_gain of dollar_figure c f’s net_long-term_capital_gain c f included with the s_corporation return schedule d capital_gains_and_losses and built-in gains s_corporation schedule d in that schedule c f’s net_long-term_capital_gain included a gain of dollar_figure from a trade secret sale and a loss of dollar_figure from a long term stock sale the dollar_figure that c f reported as a trade secret sale in the s corpora- tion schedule d is equal to the amount of the pizza hut payment that the niro law firm distributed to c f on date in the s_corporation return c f also reported an ordinary_loss from trade_or_business activities of dollar_figure c f’s ordinary_loss c f issued to each stockholder petitioner schedule_k-1 shareholder’s share of income credits deductions etc schedule_k-1 for taxable_year in each of those schedules k-1 c f reported as net_long-term_capital_gain the stockholder petitioner’s proportionate share of c f’s net_long-term_capital_gain which included the dollar_figure that c f reported as gain from a trade secret sale in the s_corporation schedule d in each schedule_k-1 c f also reported as an ordinary_loss from trade_or_business activities the stockholder petitioner’s proportionate share of c f’s ordinary_loss petitioners or petitioner as the case may be in each of these cases filed form_1040 u s individual_income_tax_return for taxable_year that included schedule d capital_gains_and_losses schedule d and schedule e supplemental income and loss schedule e those respective schedules d showed as net long-term gain the stockholder petitioners’ respective proportionate shares of c f’s net_long-term_capital_gain as reported in the respective schedules k-1 that c f issued to them the respective schedules e showed as nonpassive 8in their respective schedules d stockholder petition- ers maria e maude kathryn newcome and michael olson reported amounts of net_long-term_capital_gain that flowed through to them that were different from the amounts of net_long-term_capital_gain that c f reported in the respective schedules k-1 that it issued to them the record does not explain those differ- ences in any event the amounts of net_long-term_capital_gain that c f reported in the respective schedules k-1 that it issued to stockholder petitioners maria e maude kathryn newcome and michael olson reflected their respective proportion- ate shares of c f’s net_long-term_capital_gain reported in the s_corporation schedule d losses from c f the stockholder petitioners’ respective propor- tionate shares of c f’s ordinary_loss as reported in the respec- tive schedules k-1 that c f issued to them respondent issued respective notices of deficiency for taxable_year to petitioners in these cases notices in the notices respondent determined that the amount that pizza hut paid to c f during pursuant to the settlement agreement is ordinary_income and not long-term_capital_gain to c f for that year in those notices respondent also determined that the dollar_figure that the niro law firm distributed to the redeemed stockholder on date is ordinary_income to c fdollar_figure as a result of those determinations respondent further determined to decrease the amount of long-term_capital_gain reported in the schedules d and increase the amount of ordinary_income reported in the schedules e 9in their respective schedules e stockholder petition- ers joseph m freda and maria e maude reported amounts of ordinary_loss that flowed through to them that were different from the amounts of ordinary_loss that c f reported in the respective schedules k-1 that it issued to them the record does not explain those differences in any event the amounts of ordinary_loss that c f reported in the respective schedules k-1 that it issued to stockholder petitioners joseph m freda and maria e maude reflected their respective proportionate shares of c f’s ordinary_loss reported in the s_corporation return 10respondent concedes the issue involving the redeemed stockholder that is because in the event the court were to hold that the dollar_figure that the niro law firm distributed to that stockholder is includible in c f’s income for respondent would concede that c f is entitled to a deduction in an equal amount for that year opinion petitioners bear the burden of establishing that the amount that pizza hut paid to c f pursuant to the settlement agreement amount at issue is long-term_capital_gain and not ordinary_income to c f for taxable_year that flows through propor- tionately to its respective stockholder petitioners for that yeardollar_figure see rule a 290_us_111 it is petitioners’ position that the amount at issue is long-term_capital_gain to c f for taxable_year in support of that position petitioners advance three alternative argu- ments according to petitioners pizza hut paid the amount at issue for damage to the c f trade secret a capital_asset in c f’s hands petitioners’ principal argument c f’s sale_or_exchange of the c f trade secret to pizza hut or the termination of c f’s rights under the pizza hut confidentiality agreement with respect to the c f trade secret we turn first to petitioners’ principal argument in support of that argument petitioners assert and respondent does not dispute that the taxability of the proceeds of a lawsuit 11petitioners do not claim that the burden_of_proof shifts to respondent under sec_7491 12all rule references are to the tax_court rules_of_practice and procedure all section references are to the internal_revenue_code code in effect for the year at issue or of a sum received in settlement thereof depends upon the nature of the claim and the actual basis of recovery 36_tc_1173 affd 311_f2d_210 7th cir see also 836_f2d_1176 9th cir 568_f2d_28 7th cir where the recovery represents damages for lost profits or other items taxed as ordinary_income it is taxable as ordinary_income see 313_us_28 48_tc_465 where the recovery represents damages for injury to or destruction of a capital_asset it is taxable as capital_gain to the extent that it exceeds the taxpayer’s basis in the assetdollar_figure see 58_tc_459 state fish corp v commissioner supra pincite the parties do not dispute that the only claim outstanding against pizza hut at the time pizza hut and the c f parties entered into the settlement agreement was the pizza hut misappro- priation claim nor do they dispute that a trade secret like the c f trade secret is a capital_asset see 77_tc_524 the parties’ dispute is 13to the extent that the recovery does not exceed the tax- payer’s basis in the capital_asset it is a return_of_capital and not taxable see eg 48_tc_465 petitioners do not claim that the amount at issue is not taxable whether the amount at issue that pizza hut paid to c f represented damages for injury to or destruction of the c f trade secret petitioners maintain that the value of the c f trade secret was the right to a competitive advantage by using a process unknown to others and that pizza hut destroyed the c f trade secret when it disclosed that trade secret to ibp and terminated c f as a supplier from those premises petitioners conclude the amount_paid by pizza hut to settle c f’s claim for misappropriation of trade secrets is therefore prop- erly treated as capital_gain because amounts received for injury or damage to capital assets are taxable as capital_gain inco electroenergy corp v commis- sioner t c memo -437 state fish corp v commissioner supra pincite petitioners’ conclusion does not logically follow from the premises on which it is based it also disregards the fundamen- tal principle with which petitioners agree that the tax treat- ment of the amount at issue depends upon the nature of the claim and the actual basis of recovery sager glove corp v commis- sioner supra pincite in the pizza hut misappropriation count c f alleged in pertinent part pizza hut misappropriated such trade secrets by among other things a acquiring the trade se- crets through fraudulent misrepresentations and omis- sions and b disclosing and using such trade secrets after notice without express or implied consent of c f as a result c f has been damaged and has suffered among other things lost profits lost oppor- tunities operating losses and expenditures petitioners argue that c f’s allegations in paragraph of the pizza hut misappropriation count specified lost profits lost opportunities operating losses and expenditures solely as a measure of pizza hut’s injury to or destruction of the c f trade secretdollar_figure those allegations in that paragraph belie that argumentdollar_figure c f alleged in paragraph of the pizza hut misapp- ropriation count that as a result of pizza hut’s misappropria- tion of the c f trade secret alleged in paragraph of that count c f had been damaged and had suffered among other things 14petitioners also argue that c f could not have recovered and did not recover any lost profits from pizza hut because it recovered lost profits from ibp as a result of the judgment of the district_court which was based upon a jury verdict and which the court_of_appeals affirmed that ibp was to pay c f dollar_figure in damages with respect to the ibp misappropriation count that argument assumes that any profits that c f may have lost which were attributable to ibp’s misappropriation of the c f trade secret were the same as any profits that c f may have lost which were attributable to pizza hut’s alleged misappropriation of that trade secret on the record before us we reject peti- tioners’ argument and the assumption on which it is based on that record we find that petitioners have failed to carry their burden of establishing that any lost profits of c f that were attributable to ibp’s misappropriation of the c f trade secret were the same as any lost profits of c f that were attributable to pizza hut’s alleged misappropriation of that trade secret 15c f’s allegations in paragraph of the pizza hut misap- propriation count also belie any suggestion in the uncorroborated testimony on which we are unwilling to rely of the president of c f petitioners’ only witness at trial that pizza hut did not pay the amount at issue to c f as damages for c f’s lost profits and the other items specified in that paragraph lost profits lost opportunities operating losses and expendi- tures on the record before us we find that petitioners have failed to carry their burden of establishing that c f specified in paragraph of the pizza hut misappropriation count lost profits lost opportunities operating losses and expenditures and other unidentified items covered by among other things solely as a measure of pizza hut’s injury to or destruction of the c f trade secret on that record we find that c f asserted a claim in paragraph of the pizza hut misappropriation count for the items specified therein as the damage to and the suffer- ing of c f resulting from pizza hut’s alleged misappropriation of the c f trade secret on the record before us we further find that petitioners have failed to carry their burden of establish- ing that the damages that c f claimed in the pizza hut misappro- priation count were for injury to or destruction of the c f trade secret on that record we find that in settlement of c f’s claim in the pizza hut misappropriation count which was the only claim outstanding against pizza hut at the time of the execution of the settlement agreement pizza hut paid the amount at issue to c f for lost profits lost opportunities operating losses and expenditures dollar_figure on the record before us we find 16pizza hut and the c f parties entered into the settlement agreement continued that petitioners have failed to carry their burden of establish- ing that that amount did not represent damages for lost profits or other items taxed as ordinary incomedollar_figure on that record we find that petitioners have failed to carry their burden of establishing that the amount at issue is long-term_capital_gain to c f for taxable_year under petitioners’ principal argu- ment we turn next to petitioners’ alternative argument that the amount at issue is long-term_capital_gain to c f for taxable_year because it represents gain from c f’s sale_or_exchange during that year of the c f trade secret to pizza hut pursuant to sec_1222 a sale_or_exchange of a capital_asset is a prerequisite to capital_gain treatment see dobson v continued in order to provide for a lump-sum payment in full and complete discharge and settlement of the c f 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 and circum- stances described in the c f lawsuit 17as discussed above c f claimed in paragraph of the pizza hut misappropriation count that c f had been damaged and had suffered not only lost profits but also lost opportuni- ties operating losses and expenditures on the record before us we find that petitioners have failed to carry their burden of establishing what lost opportunities operating losses and expenditures c f had suffered that would result in long-term_capital_gain and not ordinary_income to c f for taxable_year assuming arguendo that petitioners had carried that burden on the record before us we would find that petitioners have failed to carry their burden of establishing the portion of the amount at issue that is long-term_capital_gain to c f for that year commissioner 321_us_231 since the code does not define the words sale and exchange for purposes of sec_1222 we shall give those words their ordinary meaning see 313_us_247 a sale is ‘a transfer of property for a fixed price in money or its equivalent’ 380_us_563 quoting 110_us_471 an exchange occurs when property is transferred in return for other_property 7_bta_588 see also 77_tc_9 in determining whether a transfer of rights in a trade secret constitutes a sale of the trade secret courts generally have applied the tests developed in the context of a transfer of a patent see 378_f2d_595 5th cir 55_tc_928 sec_1235 provides in pertinent part that a transfer of property consisting of all_substantial_rights_to_a_patent shall be considered the sale_or_exchange of a capital_asset held for more than year thus in order for the transfer of a trade secret to qualify as a sale_or_exchange the owner of the trade secret must transfer all substantial rights to it see 419_f3d_554 6th cir affg tcmemo_2004_53 for purposes of sec_1235 the term all substantial rights means all rights which are of value at the time the rights are transferred sec_1_1235-2 income_tax regs in the context of a trade secret the most significant rights held by its owner are the rights to prevent the unauthorized use and the unauthorized disclosure of the secret see 467_us_986 e i du pont de nemours co v united stat288_f2d_904 209_fsupp_30 e d mich on the record before us we find that under the settlement agreement c f did not transfer to pizza hut any rights let alone the most significant rights to the c f trade secret viz the rights to prevent the unauthorized use and the unauthorized disclosure of that trade secret on that record we further find pizza hut did not pay the amount at issue under the settlement agreement for c f’s sale_or_exchange of the c f trade secret to pizza hut on the record before us we find that petitioners have failed to carry their burden of establishing that under sec_1222 the amount at issue is long-term_capital_gain to c f for taxable_year we turn finally to petitioners’ alternative argument that the amount at issue is capital_gain to c f for taxable_year because pizza hut paid that amount for the termination of the rights of c f under the pizza hut confidentiality agreement with respect to the c f trade secret in support of that argument petitioners rely on sec_1234a sec_1234a provides in pertinent part sec_1234a gains or losses from certain terminations gain_or_loss attributable to the cancellation lapse expiration or other termination of-- a right or obligation with respect to property which is a capital_asset in the hands of the taxpayer shall be treated as gain_or_loss from the sale of a capital_asset petitioners argue that the pizza hut confidentiality agree- ment gave to c f the rights to require pizza hut to keep the c f trade secret confidential refrain from using that trade secret except for purposes of evaluating the sausage product and return all materials relating to the trade secret according to petitioners the settlement agreement terminated those con- tractual rights in support of that assertion c f maintains that in the settlement agreement c f released pizza hut from any claims or obligations for any injury damage or loss arising directly or indirectly from pizza hut’s relationship with c f as a pizza hut product supplier after entering into the settlement agreement c f could not pursue any claims and pizza hut had no obligations arising from pizza hut’s relationship with c f as a pizza hut sup- plier which encompasses the contractual rights in the pizza hut confidentiality agreement the payment pizza hut made in exchange for that release therefore represents a gain attributable to the termination of c f’s rights with respect to its trade secrets petitioners’ argument ignores the express terms of the settlement agreement including the following the c f parties and pizza hut acknowledge that the payment called for by this agreement is being made to compromise and settle claims disputed as to both liability and amount and is being made to c f in settlement and release of all past present and or future claims against any of the pizza hut released parties the c f parties and pizza hut acknowledge that this agreement is intended to terminate any claims by them against the released parties and to bar any future litigation between the parties hereto and that there is no agreement by pizza hut to make any payment or to do any act or thing other than as expressly stated herein on the record before us we find that petitioners have failed to carry their burden of establishing that pizza hut paid the amount at issue under the settlement agreement for the termination of the rights of c f under the pizza hut confidenti- ality agreement with respect to the c f trade secret on that record we find that petitioners have failed to carry their burden of establishing that under sec_1234a the amount at issue is long-term_capital_gain to c f for taxable_year based upon our examination of the entire record before us we find that petitioners have failed to carry their burden of establishing that the amount at issue is long-term_capital_gain to c f for taxable_year on that record we sustain respon- dent’s flow-through determinations in the notices issued to the respective petitioners that are at issue in these cases we have considered all of the contentions and arguments of the parties that are not discussed herein and we find them to be without merit irrelevant and or moot to reflect the foregoing and the concession by respondent decisions will be entered under rule


internal_revenue_service number release date index number ----------------------------------- --------------------------- -------------------------- ------------------------------------ department of the treasury washington dc third party communication none date of communication not applicable_person to contact ----------------------- id no ------------------- --------------------------------------------------- telephone number ---------------------- refer reply to cc psi b03 plr-122662-13 date date x ------------------------- ------------------------------------------------------------ legend h -------------------------------------------------------------- ----------------------- w --------------------------- trust -------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------ ------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------------------------------------------------------------------- ------------------------------------------------------ ------------------------------------------------------------------------------ ------------------------------------------------------------ d1 d2 -------------------- ----------------- dear -------------- this letter responds to a letter dated date and subsequent correspondence submitted on behalf of x requesting a ruling under sec_1362 of the internal_revenue_code code plr-122662-13 facts the information submitted states that x is a corporation that made an election to be treated as a subchapter_s_corporation all of the stock in x was community_property held by trust a grantor_trust described in sec_1361 of which h and w were the deemed owners w died on d1 relative to w’s share of x stock trust qualified under sec_1361 as an eligible shareholder for two years from w’s date of death however trust continued to hold the x stock after the two-year period as a result x’s s_corporation_election terminated on d2 the day after the two-year period following w’s death according to x trust qualifies as an electing_small_business_trust esbt but its trustee made no esbt election x represents that the circumstances resulting in the termination of x’s s_corporation_election were inadvertent and were not motivated by tax_avoidance or retroactive tax planning x and its shareholders have agreed to make such adjustments consistent with the treatment of x as an s_corporation as may be required by the service law and analysis sec_1361 provides that for purposes of sec_1361 a_trust which was described in sec_1361 immediately before the death of the deemed owner and which continues in existence after such death may be a shareholder but only for the 2-year period beginning on the day of the deemed owner’s death sec_1361 provides that for purposes of sec_1361 an esbt may be a shareholder sec_1362 provides that if an election under sec_1362 by any corporation a was not effective for the taxable_year for which made determined without regard to sec_1362 by reason of a failure to meet the requirements of sec_1361 or to obtain shareholder consents or b was terminated under sec_1362 or the secretary determines that the circumstances resulting in the ineffectiveness or termination were inadvertent no later than a reasonable period of time after discovery of the circumstances resulting in the ineffectiveness or termination steps were taken a so that the corporation is a small_business_corporation or b to acquire the shareholder consents and the corporation and each person who was a shareholder of the corporation at any time during the period specified pursuant to sec_1362 agrees to make such adjustments consistent with the treatment of the corporation as an s_corporation as may be required by the secretary with respect to such period then notwithstanding the circumstances resulting in the ineffectiveness or plr-122662-13 termination the corporation will be treated as an s_corporation during the period specified by the secretary conclusion based solely on the facts submitted and representations made we conclude that x’s election to be treated as an s_corporation terminated on d2 after the two-year period following w’s death we also conclude that the termination constituted an inadvertent termination within the meaning of sec_1362 accordingly x will be treated as continuing to be an s_corporation from d2 and thereafter provided that x’s s_corporation_election was otherwise valid and was not otherwise terminated under sec_1362 in addition trust will be treated as an esbt from d2 and thereafter provided the trustee of trust files an esbt election for trust with the appropriate service_center effective d2 within days of the date of this letter a copy of this letter should be attached to that election this ruling is contingent on x and all its shareholders treating x as having been an s_corporation for the period beginning on d2 and thereafter accordingly x’s shareholders must include their pro_rata share of the separately_stated and nonseparately computed items of x as provided in sec_1366 make any adjustments to basis as provided in sec_1367 and take into account any distributions made by x as provided in sec_1368 if x or its shareholders fail to treat themselves as described above this ruling shall be null and void except as expressly provided herein we express or imply no opinion concerning the federal tax consequences of any aspect of any transaction or item discussed or referenced in this letter specifically we express or imply no opinion regarding whether x is otherwise eligible to be treated as an s_corporation this ruling is directed only to the taxpayer that requested it sec_6110 provides that it may not be used or cited as precedent pursuant to a power_of_attorney on file we are sending a copy of this letter to x’s authorized representative sincerely s richard t probst senior technician reviewer office of the associate chief_counsel passthroughs special industries enclosures copy of this letter copy for sec_6110 purposes


internal_revenue_service number release date index number ------------------ ------------------------------- ------------------------ ---------------------------------- department of the treasury washington dc third party communication none date of communication not applicable_person to contact ------------------- id no ------------- telephone number --------------------- refer reply to cc psi b01 plr-116920-09 date date legend x ------------------------------------------- ----------------------------------- state d1 ---------- ------------------- dear -------------- this letter responds to the letter dated date and subsequent correspondence submitted on behalf of x requesting a ruling that x be granted an extension of time under sec_301_9100-3 of the procedure and administration regulations to file an election under sec_301_7701-3 to be treated as an association_taxable_as_a_corporation for federal tax purposes and requesting relief to file a late s_corporation_election under sec_1362 of the internal_revenue_code facts according to the information submitted x was formed as a professional limited_liability_company under the laws of state on d1 the members of x intended that x be treated as an s_corporation effective on d1 but the election to be treated as an s_corporation was not timely filed a form_8832 entity classification election for x to be an association_taxable_as_a_corporation was also not timely filed for x under the default rules of the entity classification regulations x is classified as a partnership law and analysis plr-116920-09 sec_301_7701-3 provides in part that a business_entity that is not classified as a corporation under sec_301_7701-2 or an eligible_entity can elect its classification for federal tax purposes an eligible_entity with at least two members can elect to be classified as either an association or a partnership and an eligible_entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner sec_301_7701-3 provides that except for certain existing entities described in sec_301_7701-3 unless a domestic eligible_entity elects otherwise the entity is a partnership if it has two or more members under sec_301_9100-1 the commissioner may grant a reasonable extension of time to make a regulatory election or a statutory election but no more than six months except in the case of a taxpayer who is abroad under all subtitles of the code except subtitles e g h and i sec_301_9100-1 defines the term regulatory election as including an election whose due_date is prescribed by a regulation published in the federal_register sec_301_9100-1 through provide the standards that the commissioner will use to determine whether to grant an extension of time to make an election sec_301_9100-1 sec_301_9100-2 provides automatic extensions of time for making certain elections sec_301_9100-3 provides extensions of time for making elections that do not meet the requirements of sec_301_9100-2 requests for relief under sec_301_9100-3 will be granted when the taxpayer provides evidence to establish that the taxpayer acted reasonably and in good_faith and that granting relief will not prejudice the interests of the government sec_301 a sec_1362 provides that a small_business_corporation may elect to be an s_corporation sec_1362 provides the rule on when an s election will be effective sec_1362 provides in relevant part that if an s election is made within the first two and one-half months of a corporation's taxable_year then the corporation will be treated as an s_corporation for the year in which the election is made under sec_1362 however if an s election is made after the first two and one- half months of a corporation's taxable_year then that corporation will not be treated as an s_corporation until the taxable_year after the year in which the s election is filed plr-116920-09 sec_1362 provides that if no sec_1362 election is made for any taxable_year and the secretary determines that there was reasonable_cause for the failure to timely make such election then the secretary may treat such an election as timely made for such taxable_year and sec_1362 shall not apply conclusion based solely on the facts submitted and the representations made we conclude that the requirements of sec_301_9100-3 have been satisfied as a result x is granted an extension of time of days from the date of this letter to make an election to be treated as an association_taxable_as_a_corporation for federal tax purposes effective d1 x should make the election by filing a properly executed form_8832 with the appropriate service_center a copy of this letter should be attached to the form we further conclude that x has reasonable_cause for failing to make a timely s election and therefore x is eligible for relief under sec_1362 accordingly provided that x makes the above entity classification election x otherwise qualifies as an s_corporation and within days from the date of this letter x submits a properly completed form_2553 with a copy of this letter attached to the appropriate service_center x will be treated as an s_corporation effective d1 except as specifically provided herein no opinion is expressed or implied concerning the federal tax consequences of the facts described above under any other provision of the code this ruling is directed only to the taxpayer requesting it sec_6110 of the internal_revenue_code provides that it may not be used or cited as precedent pursuant to the power_of_attorney on file with this office a copy of the letter is being sent to x’s authorized representative sincerely curt g wilson curt g wilson associate chief_counsel passthroughs and special industries enclosures copy of this letter copy for sec_6110 purposes