Page 67 - Calculating Lost Profits

tlement amount as a nontaxable return of capital. The IRS Commissioner disagreed and determined that
the $350,000 was taxable income.

Raytheon lost its case at trial and thereafter appealed. On appeal (Raytheon Production Corporation v.
Commissioner, 144 F.2d 110 (1st Cir. 1944)), the First Circuit wrote that “recoveries which represent a
reimbursement for lost profits are income.” Typically, profits would be taxable income, so by deduction,
proceeds of litigation to replace lost profits are also taxable. In other words, lost profits damages (or set-
tlements received as compensation in the context of a lawsuit) are received “in lieu of” profits that
would have been taxable.

Raytheon argued that the illegal conduct of RCA destroyed its business, and the lawsuit sought not to
recover lost profits but, rather, the lost business and goodwill value. A return of lost business value rep-
resents a return of capital, which is not taxable. The First Circuit opinion explained that even if the set-
tlement was a return of capital, at least some of which could be taxable as a conversion of property into
cash, creates a gain to the extent that monies received exceed the cost or basis of the business or good-
will. In the Raytheon matter, there was no evidence of the basis of the business or goodwill, so the entire
total of the amount Raytheon had excluded from income was taxable, albeit as a capital gain.

Gilmore’s “Origin of the Claim” Test for Damages or Settlements Paid

The corollary to the “in lieu of” test (for recipients of damages or settlements), applying to the payor of
damages or settlements (including fees), is the “origin of the claim” test, first seen in United States v.
Gilmore, 372 U.S. 39 (1963). In the underlying dispute, a marital dissolution, Gilmore’s wife claimed
that Gilmore’s interests in three companies were community property, with which Gilmore disagreed.
Gilmore prevailed but spent approximately $40,000 defending against the wife’s claim. Thereafter, he
deducted the litigation expenses as ordinary and necessary expenses incurred for the conservation of
property held for the production of income (formerly 26 U.S.C. § 23(a)(2) and currently Code Section
212). The IRS found Gilmore’s expenditures to be “personal” or to pertain to “family” and, therefore,
not deductible.

The U.S. Supreme Court agreed with the IRS and determined that litigation costs are deductible only if
the claim arises in connection with the taxpayer’s profit-seeking activities. Deductibility depends on “the
origin and nature of the claims.” Here, Gilmore’s legal expenses did not become deductible just because
they were incurred to relieve him of a liability. Were that to be the case, costs incurred to defend almost
any claim would be deductible by a taxpayer as the defense was made to clear liens on an income-
producing property that the taxpayer owned. Instead, the legal claim must arise in connection with the
business or profit-seeking activity at issue. In Gilmore, he was defending against claims originating from
his personal divorce, not on a claim against the profit-generating business. The fact that the claim would
affect his income-producing property (for example, if he had to liquidate an interest to pay the wife) was
irrelevant. The origin of the claim doctrine evaluates the tax consequence of a damages or settlement
payout and fees incurred based on the origin and character of the claim with respect to which the ex-
pense was incurred.

Timing of Profits Lost Versus Damages Received

Even when the “in lieu of” test matches the nature of the lost income with the tax treatment of the dam-
ages award or settlement, there can be differences in effective tax rates, which will call for taxes to be
explicitly addressed in a damages calculation. For example, this can occur when an injured party is paid
a judgment in a time period that has different tax rates than were or would have been in effect when the
lost profits would have been earned. This might occur when tax rates have changed from one year to an-

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