Rev. Rul. 74-251

Advice has been requested whether, under the circumstances described below, an amount received in settlement of litigation constitutes a long-term capital gain within the meaning of section 1222(3) of the Internal Revenue Code of 1954.

For many years X corporation had been the investment advisor and principal underwriter for Y corporation, a regulated investment company. In 1968 X negotiated and entered into an exclusive new and profitable investment advisory contract with Y. Shortly thereafter, the majority shareholders of X, certain of whom were directors of Y, sold their stock in X at a substantial profit.

In 1970 a law suit was filed on behalf of Y by certain of its shareholders against the former shareholders of X. In that suit Y made the following allegation:

The right to select Y's investment advisor and principal underwriter is an asset of Y and not of X. Y could have negotiated with X and with other investment advisors and principal underwriters and auctioned or sold the right to act as investment advisor and principal underwriter at a price corresponding to the price reflecting the value which the old shareholders received for their shares of X. Thus, the consideration received by the old shareholders for the sale of stock in X rightfully belonged to Y, and the retention thereof by the old shareholders constitutes an appropriation of the assets of Y.

Subsequent to the trial of the case, but prior to decision by the court, a stipulation of settlement was entered into by the respective parties to the action. Pursuant to the settlement, certain of the former shareholders of X paid Y a specified amount in total settlement of the allegation.

Section 1222(3) of the Code provides that the term "long-term capital gain" means gain from the sale or exchange of a capital asset held for more than 6 months, if and to the extent such gain is taken into account in computing gross income.

In the instant case, Y contends that the amount received from the former shareholders of X represents compensation for their taking and profiting from a portion of Y's capital fabric, Y's intangible right to select its investment advisor. Y further contends that such taking of its right by X's shareholders, and their subsequent payment for it in form of a settlement, is tantamount to a sale of such right. Y concludes that since its intangible right is a capital asset held for more than 6 months, it is entitled to treat the proceeds as a long-term capital gain.

An analysis of Y's contentions show that there was no sale or exchange of its assets. X's shareholders, in causing X to obtain a profitable contract with Y as an investment advisor, profited from the value of that contract in selling their stock in X. While it may be true that X's shareholders used Y's right to select an investment advisor to produce a profit for themselves, they clearly did not purchase such right upon the settlement of the litigation. In effect, Y merely recovered from X's shareholders amounts they received from the purchasers of X's stock representing anticipated profits from an advisory contract held by X.

Unless it can be clearly established that there has been a sale or exchange of property, money received in settlement of litigation is ordinary income. The mere settlement of a law suit does not in itself constitute a sale or exchange. See Paul E. Kempter, 22 CCH Tax Ct. Mem. 274 (1963).

Section 1.61-1 of the Income Tax Regulations provides, in part, that gross income means all income from whatever source derived, unless excluded by law.

Accordingly, in the instant case, it is held that the amount received by Y in settlement of litigation is ordinary income includible in its gross income under section 61 of the Code, and is not an amount received on the sale or exchange of a capital asset and, thus, does not constitute a long-term capital gain within the meaning of section 1222(3).