Settlement agreement’s capital gain allocation withstands challenge by IRS

The Tax Court held that a company properly characterized as capital gain its receipt of a lump-sum settlement of claims stemming from one or more disavowed joint ventures and that the parties’ allocation in a settlement agreement should be respected.

Facts: Newport Capital Advisors LLC (NCA) was owned by David Zak. Beginning in 2005, NCA worked to find properties to develop in the Los Angeles area but needed capital. Zak connected with Commonfund Realty and its affiliates. Commonfund was interested in financing development of the properties NCA found. Both NCA and Commonfund formed additional entities to carry out the projects.

Representatives of NCA executed a deal sheet containing the major terms for a real estate development joint venture. While NCA and Commonfund were working on developing the properties, a conflict arose between them. The parties never memorialized the terms of the deal in a written agreement.

In 2008, Zak understood from a meeting with Commonfund that Commonfund did not intend to honor the terms of their joint venture and that NCA would be replaced. Commonfund later engaged another development company while NCA was still working on the projects.

In 2009, Commonfund filed a complaint in California state court against NCA, claiming NCA did not have any interest in the joint ventures and seeking remedies for numerous alleged causes of action, including breach of contract. Commonfund alleged that the parties never entered into a formal written agreement.

NCA filed a cross-complaint claiming that Commonfund had breached its fiduciary duties to NCA with respect to the joint venture. NCA alleged that its joint venture with Commonfund was reflected “in many oral and written statements and emails.” It also alleged that the parties operated according to the deal sheet.

After a trial, a jury awarded NCA damages measured by the value of its interest in the joint ventures of $16,375,968 and punitive damages totaling nearly $34 million. Commonfund appealed, and NCA and Commonfund then reached a settlement in the amount of $23 million while the appeal was pending. The parties worked on several drafts of a settlement. The final agreement provided that NCA relinquished and transferred to Commonfund “all of its rights, title, and interest … in the joint venture(s).”

In 2012, NCA received and distributed the $23 million to its entities, which reported the payments on their respective returns as long-term capital gains.

The IRS timely mailed a notice of final partnership administrative adjustment (FPAA) to each NCA entity for tax year 2012, recharacterizing the long-term capital gain as ordinary income. Each FPAA also asserted accuracy-related penalties under Sec. 6662.

The NCA entities challenged the IRS’s adjustment in the FPAAs in Tax Court.

Issues: Under Sec. 741, the sale or exchange of a partnership interest is generally treated as a sale or exchange of a capital asset. However, amounts received as compensation for lost profits and punitive damages are treated as ordinary income.

NCA argued the entire $23 million was in exchange for its joint venture interests. The IRS argued that $5 million was received for the lost joint venture interests and the remaining $18 million was compensation and punitive damages.

Holding: The Tax Court held that NCA received the settlement proceeds in exchange for its interest in the joint ventures and therefore properly treated the proceeds as gain on the sale of a capital asset.

Citing Burke, 504 U.S. 229 (1992), the court stated that the tax treatment of proceeds received in settlement of a claim is generally guided by the nature and characterization of the claim. The determination of the nature of the claim is based on the facts and circumstances. The court further pointed out that if a settlement agreement expressly allocates the settlement proceeds to a type of damages, the allocation will be followed if the agreement was reached by adversarial parties in arm’s-length negotiations and in good faith, citing Bagley, 105 T.C. 396, 406 (1995), aff’d, 121 F.3d 393 (8th Cir. 1997).

The court found that the settlement agreement expressly allocated the settlement payment, stating that it was made in exchange for the interests in the joint ventures. The court further determined that NCA and Commonfund negotiated the settlement agreement in good faith and at arm’s length, finding that this standard was met because the parties had adverse interests in how the settlement payments were characterized.

The court also concluded that the overall facts and circumstances surrounding the settlement agreement demonstrated that the payment was made in exchange for the joint venture interests. It first observed that in the state court case, the court instructed the jurors that, if they found a breach of fiduciary duty by repudiation, the proper damages would be the reasonable value of the joint venture interests. The court was not persuaded by the IRS’s attempt to disassociate the substance of the underlying court case from the payment to NCA by claiming that the settlement agreement was not a sale of the joint interests but instead was to satisfy the amended state court judgment of $23 million.

Additionally, the IRS unsuccessfully attempted to analogize the case to Healthpoint, Ltd., T.C. Memo. 2011-241, where the Tax Court did not accept the parties’ allocations of an award of punitive damages. The court rejected this argument because in that case the parties were not adverse as to the allocation of the damages, while the NCA entities and Commonfund were.

• NCA Argyle LP, T.C. Memo. 2020-56

— By Maria M. Pirrone, CPA, LL.M., associate professor of taxation, St. John’s University, Queens, N.Y.