Settlement treated as partnership interest payment

Tax Hot Topics newsletter The Tax Court recently respected an agreement to treat cash paid to settle a lawsuit as a payment in exchange for a partnership interest in NCA Argyle LP et al. v. Commissioner (T.C. Memo. 2020-56). As a result, the gain recognized from the settlement payment was properly treated as gain on the sale of a capital asset. The case highlights the need to consider tax consequences when settling litigation and demonstrates taxpayers’ ability to structure settlement payments, within limits, to achieve their desired tax treatment.

NCA, a real estate development company, and Commonfund, agreed to terms to form a real estate joint venture. Ultimately, the relationship between NCA and Commonfund broke down, and Commonfund sought to replace NCA with another development company in the joint venture. The parties entered litigation, where a jury found that Commonfund breached its fiduciary duty in repudiating the joint venture and awarded damages to NCA. While appeals were still pending, Commonfund agreed to pay NCA $23 million to settle the litigation.

The settlement agreement expressly allocated the settlement proceeds to payment for NCA’s interest in the joint venture and NCA reported the proceeds as gain from the sale of its partnership interest, a capital asset. The IRS sought to re-characterize NCA’s receipt of all or a portion of the settlement payment as ordinary income.

The Tax Court explained that the tax treatment of proceeds received in settlement of a claim is generally guided by the nature of the claim and ruled in favor of NCA, noting that it will generally follow the allocation of settlement proceeds in a settlement agreement if the agreement was reached by adversarial parties in arm’s-length negotiations and in good faith. The court noted that, while Commonfund might be able to deduct a settlement payment allocated to punitive damages or lost fee income, NCA sought to treat the settlement as a non-deductible payment for its partnership interest in order to obtain preferential capital gains rates. The Tax Court found that NCA and Commonfund had adverse interests in the settlement negotiations, negotiated at arm’s-length and in good faith, and upheld the allocation contained in the settlement agreement. Accordingly, it concluded that the NCA entities properly treated the settlement proceeds as gain on the sale of a capital asset.

The IRS also argued that the settlement payment should be treated as ordinary income because, in substance, it represented compensation to NCA for the loss of fee income it would have received from the joint venture, and that would have been ordinary in character. During the litigation with Commonfund, NCA sought to establish the value of its interest in the joint venture based, in part, on the anticipated fee income. The court disagreed, noting that the settlement agreement expressly valued NCA’s interest in the joint venture, and that the anticipated fee income was merely a component of that value.

The case illustrates the flexibility that taxpayers have in determining the tax treatment of settlement payments. However, this flexibility also presents a trap for the unwary, as a taxpayer who fails to consider the tax impact of allocations of settlement proceeds in advance could find itself saddled with an unfavorable tax treatment later. Taxpayers entering into settlement agreements should carefully consider the tax implications in order to prevent unanticipated tax consequences and maximize the opportunity to structure the settlement in a favorable manner. Additionally, in the case of a settlement where a partnership interest is treated as sold, consideration may need to be given to the implications of such sale treatment under the partnership tax rules.

Grace Kim
Principal, Partnerships
Washington National Tax Office 
T +1 202 521 1590

Jose Carrasco
Senior Manager, Partnerships
Washington National Tax Office 
T +1 202 521 1552

Whit Cocanower
Washington National Tax Office
T +1 202 521 1541

Sarah Barlow
Senior Associate
Washington National Tax Office
T +1 202 521 1505

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