## Facts

- C & F Packing Co., Inc. (C & F), an S corporation, developed a patented and trade-secret process for producing pre-cooked frozen sausage for Pizza Hut.
- Pizza Hut sought nationwide uniformity and required C & F to share process information with other suppliers; Pizza Hut agreed to keep the information confidential.
- C & F entered confidential licensing arrangements with certain other suppliers, receiving licensing fees in exchange for access and confidentiality.
- C & F alleged Pizza Hut disclosed key process information to IBP, Inc., a competitor not bound by a confidentiality or licensing agreement, enabling IBP to replicate the process and sell sausage to Pizza Hut at lower prices.
- C & F claimed Pizza Hut’s conduct caused lost sales, lost profits, and other business harms.
- C & F sued Pizza Hut and IBP; after litigation developments, C & F obtained a verdict against IBP and later settled its remaining trade-secret misappropriation claim against Pizza Hut for $15.3 million.
- After attorneys’ fees and other payments, C & F’s net settlement proceeds from Pizza Hut were $6.12 million, which C & F and its shareholders reported as long-term capital gain.
- The IRS recharacterized the shareholders’ pass-through settlement proceeds as ordinary income; the Tax Court agreed with the IRS and entered deficiencies.

## Issues

1. Whether the net settlement proceeds paid to C & F to resolve a trade-secret misappropriation claim were taxable as ordinary income or as long-term capital gain.
2. Whether the settlement, in substance, was consideration for the sale/exchange or destruction of a capital asset (the trade secret) rather than compensation for lost profits and other ordinary-income items.

## Decision

- The Seventh Circuit affirmed the Tax Court’s deficiency determinations.
- The court held the $6.12 million net settlement proceeds were ordinary income.
- Applying the origin-of-the-claim analysis, the court concluded the settlement functioned primarily as a substitute for lost profits and related business income.
- The court rejected capital-gain treatment because the record did not show the settlement reflected a sale or exchange of the trade secret, or an equivalent disposition of a capital asset; C & F retained its process.
- Judge Manion dissented in part, favoring a more capital-asset-based characterization for at least some portion of the settlement.

## Legal Principles

- The tax character of settlement proceeds turns on the origin and nature of the claim settled—specifically, what the payment was intended to replace.
- Recoveries substituting for lost profits, lost sales, or other ordinary business income are taxed as ordinary income, even if the dispute involves intellectual property.
- Although trade secrets may qualify as capital assets, capital-gain treatment generally requires a showing that the payment was for a sale or exchange (or comparable disposition) of the asset, not merely compensation for impaired earnings.
- The taxpayer bears the burden of substantiating entitlement to capital-gain treatment based on the substance of the claim, the damages theory, and the settlement context.

## Conclusion

The court treated the settlement as ordinary income because the settled claim and alleged damages centered on replacement of lost profits and related business income, not on a transaction disposing of C & F’s trade secret as a capital asset.


Freda v. Comm’r, 656 F.3d 570 (7th Cir. 2011)