In the
United States Court of Appeals
For the Seventh Circuit
No. 10-1555
JOSEPH A. F REDA, et al,
Petitioners-Appellants,
v.
C OMMISSIONER OF INTERNAL R EVENUE,
Respondent-Appellee.
Appeal from the United States Tax Court.
Nos. 12874-07, 16255-07, 16256-07,
16257-07, 16258-07, 16259-07, 16260-07,
16261-07, 16262-07—Carolyn P. Chiechi, Judge.
A RGUED S EPTEMBER 30, 2010—D ECIDED A UGUST 26, 2011
Before F LAUM, M ANION, and T INDER, Circuit Judges.
T INDER, Circuit Judge. Sausage manufacturer C&F
Packing Co., Inc., brought a variety of claims against
its former business partner, Pizza Hut, Inc., in 1993.
After a trial, a trip to the United States Court of Appeals
for the Federal Circuit, and a lot of legal wrangling,
C&F agreed in 2002 to drop its last remaining claim,
trade secret misappropriation, in exchange for a $15.3
2 No. 10-1555
million payment from Pizza Hut. Closing the book on
the long-running lawsuit merely opened a new chapter
of legal difficulties for C&F and its shareholders, how-
ever. When it received its $6.12 million take-home
portion of the settlement, C&F, an S corporation, reported
the income to the Internal Revenue Service as long-
term capital gain. Its shareholders reported their passed-
through pro rata shares of the settlement the same way.
The Commissioner of Internal Revenue concluded
that the settlement income should have been taxed as
ordinary income and issued each of the shareholders
(and, in some cases, their jointly filing spouses, whom
we will include among “the shareholders”) a deficiency
notice. The shareholders challenged the determination
in the tax court, which agreed with the Commissioner’s
treatment of the settlement income and ordered deficiency
judgments. The shareholders now appeal. We affirm.
I. Background
C&F is an Illinois-based meat processing company. In
the early 1980s, C&F developed a process for making
and freezing pre-cooked sausage that had the appear-
ance and taste of home-cooked sausage. C&F applied
for and obtained a patent protecting its new process.
C&F treated as trade secrets all subsequent refinements
to the process; we use the term “C&F process” to refer
to the process and related trade secrets.
In 1985, one of C&F’s long-time customers, Pizza Hut,
expressed an interest in using sausage made pursuant
to the C&F process in its outlets nationwide, which
No. 10-1555 3
would result in purchases of at least 200,000 pounds
per week. The catch was that C&F had to agree to share
the C&F process with Pizza Hut’s other sausage
suppliers so that Pizza Hut could offer its customers a
uniform product. Later that year, Pizza Hut and C&F
signed an agreement pursuant to which C&F disclosed
to Pizza Hut information relating to the C&F process,
and Pizza Hut promised to keep mum about those de-
tails. C&F also entered into separate confidential licensing
agreements with several of Pizza Hut’s other suppliers,
disclosing its C&F process in exchange for promises of
confidentiality and licensing fees.
Pizza Hut faltered on its end of the bargain: it failed
to buy sufficient quantities of sausage from C&F and
allegedly—it has never admitted wrongdoing—divulged
crucial information regarding the C&F process to IBP,
Inc., another meat processing company with whom C&F
had not signed a confidentiality or licensing agree-
ment. IBP replicated the C&F process, set its prices below
C&F’s, and began selling large quantities of sausage to
Pizza Hut. Pizza Hut bought less and less sausage
from C&F, and C&F suffered financially. C&F eventu-
ally filed suit against both Pizza Hut and IBP in the
Northern District of Illinois in 1993. In its second
amended complaint, C&F alleged, inter alia, that Pizza
Hut “misappropriated [its] trade secrets by, among
other things: (a) acquiring the trade secrets through
fraudulent misrepresentations and omissions, and
(b) disclosing and using such trade secrets, after notice,
without express or implied consent of C&F.” “As a result,”
the complaint continued, “C&F has been damaged, and
4 No. 10-1555
has suffered, among other things, lost profits, lost oppor-
tunities, operating losses, and expenditures.” C&F
sought compensatory and punitive damages as well as
injunctive relief and attorneys’ fees in connection with
its trade secret misappropriation claim.
The district court dismissed all the counts against
Pizza Hut, including the claim of trade secret misappro-
priation. C&F’s trade secret misappropriation claim
against IBP proceeded to trial, however, and a jury
awarded C&F $10.9 million in damages. The district
court awarded C&F an additional $5 million in pre-judg-
ment interest. Both C&F and IBP appealed to the
Federal Circuit (one of the claims at issue was a
patent claim involving the patent for the C&F process,
which was ultimately invalidated). The Federal Circuit
affirmed the jury’s verdict on the IBP misappropriation
claim, though it vacated the district court’s interest
award. IBP promptly paid C&F the $10.9 million judg-
ment. C&F determined that it would have had approxi-
mately $2.86 million in additional profits if IBP had not
misappropriated its trade secret; it treated that portion
of its take-home from the settlement as ordinary
income and the rest as capital gain on its 2000 federal
income taxes. Its shareholders did the same and met
no resistance from the Commissioner.
The Federal Circuit also decided that the district court
had erred in dismissing C&F’s trade secret misappro-
priation claim against Pizza Hut. It remanded that
claim, the only surviving claim in the suit, back to the
Northern District of Illinois. Pizza Hut moved for sum-
No. 10-1555 5
mary judgment, but became amenable to settlement
after the district court denied that motion. Pizza Hut
and C&F settled the trade secret misappropriation claim
for $15.3 million in January 2002. The settlement agree-
ment provided for “a lump-sum payment in full and
complete discharge and settlement of the Lawsuit and
all other past, present, and future claims that could be
asserted now or in the future by the C&F Parties and
Pizza Hut related to the events or circumstances de-
scribed in the Lawsuit.” After deducting attorneys’ fees,
expenses, and a sizeable payment to a former share-
holder (who redeemed his shares to C&F in exchange
for an interest in the suit) from the settlement, C&F
walked away with $6.12 million.
C&F characterized the $6.12 million as gain from a
“trade secret sale” and reported the entire amount as long-
term capital gain on its 2002 federal income tax form.
The Schedule K-1s that C&F distributed to the share-
holders characterized the settlement proceeds the same
way. The shareholders in turn reported their propor-
tionate shares of the settlement as long-term capital gain
on their 2002 federal income taxes.
In March 2007, the Commissioner issued notices of
deficiency to the shareholders after determining
that the $6.12 million settlement was ordinary income,
not long-term capital gain. The former is taxed at a
higher rate than the latter; some shareholders were as-
sessed deficiencies in excess of $700,000. The Commis-
sioner also determined that the portion of the settlement
C&F allocated to the former shareholder—some $3.06
6 No. 10-1555
million—should have been reported as income by C&F
rather than deducted; the asserted deficiencies reflected
this position. The shareholders challenged the deficiency
assessments by timely filing petitions with the United
States Tax Court. See 26 U.S.C. § 6213. Their cases were
properly consolidated. After the claims proceeded to
trial, the Commissioner conceded that C&F properly
deducted the $3.06 million it paid to the former share-
holder; the sole issue remaining for the tax court was
whether the $6.12 million should have been reported as
ordinary income or long-term capital gain.
At the one-day, single-witness trial and in the briefing
that followed it, the shareholders raised three argu-
ments in support of their position that the settlement
proceeds should be taxed as long-term capital gain. First,
relying on Inco Electroenergy Corp. v. Comm’r, T.C.M. (P-H)
1987-437, which held that moneys received for injury
or damage to capital assets are taxable as capital gain,
they argued that the settlement here was payment for
damage to C&F’s trade secrets, which are capital assets,
see id.; Ofria v. Comm’r, 77 T.C. 524, 541-42 (1981). Second,
recognizing that long-term capital gain is defined in
terms of the “sale or exchange” of capital assets, see 26
U.S.C. § 1222(3), they asserted that the settlement pay-
ment represented the culmination of a “sale or ex-
change” of the trade secrets relating to the C&F process.
Finally, looking to 26 U.S.C. § 1234A, which treats as
capital gain income attributable to the termination of
certain rights or obligations, they contended that Pizza
Hut made the settlement payment to terminate C&F’s
rights under the confidentiality agreement the parties
No. 10-1555 7
signed in 1985. The tax court rejected all three argu-
ments and sustained the Commissioner’s determination
that the settlement proceeds should be taxed as ordinary
income. (The deficiencies were recalculated and re-
duced to reflect the Commissioner’s concession.) The
shareholders reassert their first two arguments in
this appeal, over which we have jurisdiction. 26 U.S.C.
§ 7482(a)(1).
II. Discussion
A. Standard of Review
We review decisions of the tax court “in the same
manner and to the same extent as decisions of the
district courts in civil actions tried without a jury.” Id.; see
generally Thomas v. Gen. Motors Acceptance Corp., 288
F.3d 305, 307-08 (7th Cir. 2002) (discussing standards
of review in such cases). The parties agree that this
means that we review conclusions of law de novo and
findings of fact for clear error. See Cole v. Comm’r, 637
F.3d 767, 773 (7th Cir. 2011). They part ways, however,
when it comes to our review of the application of law
to facts, or “mixed questions of law and fact.” The share-
holders advocate for a de novo review, e.g., Frank Lyon
Co. v. United States, 435 U.S. 561, 581 n.16 (1978); Bell
Fed. Sav. & Loan Ass’n v. Comm’r, 40 F.3d 224, 226 (7th
Cir. 1994), while the Commissioner champions a more
deferential clear error review, e.g., Kikalos v. Comm’r, 434
F.3d 977, 982 (7th Cir. 2006); Reynolds v. Comm’r, 296
F.3d 607, 612 (7th Cir. 2002). This quandary about the
8 No. 10-1555
appropriate criterion is a knotty one. See Wellpoint, Inc.
v. Comm’r, 599 F.3d 641, 644-45 (7th Cir. 2010).
Fortunately, we need not unravel it here. “We would
affirm under either standard,” id. at 645, because the
shareholders have not carried their burden of proving
that the Commissioner’s presumptively correct deficiency
assessments are erroneous, see Cole, 637 F.3d at 773 .
B. Analysis
The shareholders first “ask this Court to adopt a rule
that, as a matter of law, settlement proceeds received as
a result of a sole claim for misappropriation of a capital
asset are taxed as capital gains.” Because C&F’s claim
had at its center a capital asset, they contend, all compen-
sation C&F (and they) received in settlement of that
claim must also be treated as capital in nature.
This broad-brush approach obscures some crucial
finer points of the so-called “origin of the claim” doctrine,
the underlying principles of which are applicable here.
(It also elevates form over substance, which is generally
frowned upon in tax jurisprudence, see, e.g., Frank Lyon,
435 U.S. at 583-84, and potentially opens the door to
exploitation of the beneficial—and exceptional—capital
gains tax rate, cf. Womack v. Comm’r, 510 F.3d 1295, 1299
(11th Cir. 2007) (“Congress intended ordinary income to
be the default tax rate, with capital gains treatment an
exception only in appropriate cases.”).) The origin of
the claim doctrine had its roots in a dispute over
legal expenses a taxpayer incurred while defending his
income-producing property during a divorce dispute.
No. 10-1555 9
See United States v. Gilmore, 372 U.S. 39 (1963); Reynolds,
296 F.3d at 614. The taxpayer characterized his legal
expenses as “business” rather than “personal” in nature
because, he asserted, he was conserving his capital
assets. The Supreme Court rejected his argument,
holding that “the characterization, as ‘business’ or ‘per-
sonal,’ of the litigation costs of resisting a claim depends
on whether or not the claim arises in connection with
the taxpayer’s profit-seeking activities.” Gilmore, 372
U.S. at 48. While the doctrine in its purest form is not
directly applicable here, the principles underlying it
long have been. See, e.g., Canal-Randolph Corp. v. United
States, 568 F.2d 28, 33 (7th Cir. 1978) (per curiam). That
is, “the [tax] classification of amounts received in settle-
ment of litigation is to be determined by the nature
and basis of the action settled, and amounts received
in compromise of a claim must be considered as having
the same nature as the right compromised.” Nahey v.
Comm’r, 196 F.3d 866, 868 (7th Cir. 1999) (quoting
Alexander v. Internal Revenue Serv., 72 F.3d 938, 942 (1st
Cir. 1995)). To determine the “nature” of the “right com-
promised,” the shareholders invite us to look no further
than the title of their claim: trade secret misappropriation.
Perhaps in a different case that quick glance could
resolve the matter. But trade secret misappropriation,
aside from signaling that a capital asset may be in
some way implicated, does not tell us very much about
the actual nature of C&F’s original claim, which can
take many forms. See Restatement (Third) of Unfair Com-
petition §§ 40, 44-45 (1995) (describing trade secret
[mis]appropriation and the many factors that should
10 No. 10-1555
be considered in awarding injunctive and monetary
relief); Milgrim on Trade Secrets § 15.02 (describing
varieties of relief available in trade secret litigation).
And while the outcome of a suit is not dispositive in
making such an assessment, Wellpoint, 599 F.3d at 647
(citing Gilmore, 372 U.S. at 48-49), “the remedy sought or
ordered or agreed to can be a clue to the nature of the
claim,” id. at 648; see also Sager Glove Corp. v. Comm’r, 36
T.C. 1173, 1180 (1961) (“The taxability of the proceeds of
a lawsuit, or of a sum received in settlement thereof,
depends upon the nature of the claim and the actual basis
of recovery.” (emphasis added)), aff’d, 311 F.2d 210 (7th
Cir. 1962). Where “the recovery represents damages for
lost profits, it is taxable as ordinary income. However, if
it represents a replacement of capital destroyed or
injured, the money received . . . is a return of capital
and not taxable.” Sager Glove, 36 T.C. at 1180. We look to
what the settlement payment in question is “in lieu of.”
Canal-Randolph, 568 F.2d at 33 n.8; see also Milenbach
v. Comm’r, 318 F.3d 924, 932 (9th Cir. 2003) (“When a
claim is resolved by settlement, the relevant question
for determining the tax treatment of a settlement award
is: ‘In lieu of what were the damages awarded?’ ”);
Raytheon Prod. Corp. v. Comm’r, 144 F.2d 110, 113 (1st Cir.
1944) (same).
Here, the tax court, after reviewing the record and
hearing testimony on the matter at trial, found that
“Pizza Hut paid the amount at issue to C&F for ‘lost
profits, lost opportunities, operating losses and expendi-
tures.’ ” This finding of fact, see Alexander, 72 F.3d at 944,
which tracks the language of the relief requested in
No. 10-1555 11
C&F’s complaint and has some support in the trial testi-
mony, is not clearly erroneous, particularly when it is
viewed, as it must be, in the light most favorable to
the finding, see Pittman v. Comm’r, 100 F.3d 1308, 1313
(7th Cir. 1996). Nor is it as narrow as our dissenting
colleague appears to believe. See Dissent at 20 (“[T]he
Tax Court concluded that C&F was only seeking lost
profits against Pizza Hut.”); id. at 21 (“The Tax Court was
clearly wrong to conclude that the claim against Pizza
Hut could only be for lost profits and that it wasn’t also
to compensate the injury to its trade secret . . . .”). We
agree that a finding that C&F sought only lost profits, or
was compensated only for lost profits in the settlement,
would be “an incorrect way of reading the complaint.”
Id. at 20. But the way we see it, the tax court did not err
when it concluded that the shareholders “failed to
carry their burden that [the settlement payment] did not
represent damages for lost profits or other items taxed
as ordinary income.” Freda v. Comm’r, T.C.M. (CCH) 2009-
191 (emphasis added). (The tax court also noted that,
even assuming C&F had fulfilled that burden, it had not
met its other burden of establishing what portion of
the payment at issue should be treated as long-term
capital gain for the tax year in question.)
The tax court implicitly recognized that trade secret
misappropriation claims—and recoveries associated
with them—are rather chameleonic. Injuries caused by
trade secret misappropriation can take many forms and
may be remedied by many types of relief. See 765 Ill. Comp.
Stat. 1065 (statute that C&F claimed was violated); Kan.
Stat. Ann. § 60-3322 (statute found to apply); Restatement
12 No. 10-1555
(Third) of Unfair Competition § 45; Milgrim on Trade Secrets
§ 15.02. Among these remedies are a variety of damages,
including lost profits and royalties, that are properly
characterized as ordinary income for tax purposes. The
shareholders had the burden of demonstrating that the
Commissioner was wrong when he concluded that the
settlement payment was in lieu of one or more of these
ordinary income streams. They contend that they
carried this burden simply by pointing to the fact that
the claim was one for trade secret misappropriation.
They further argue that the tax court misapplied the
origin of the claim doctrine by considering C&F’s
requests for recovery for its lost profits, opportunities,
losses, and expenditures as more than mere metrics by
which to measure the damage to its trade secrets.
But unlike the taxpayers in the cases on which the
shareholders rely, Durkee v. Comm’r, 162 F.2d 184, 186
(6th Cir. 1947), and Inco Electroenergy, T.C.M. (P-H) 1987-
437, neither of whom ever alleged an entitlement to
lost profits, C&F sought profits and other types of mone-
tary recovery that may properly be taxed as ordinary
income from the get-go rather than focusing on the
damage to or destruction of its capital asset. The share-
holders claim C&F was using profits merely as a rough
measuring stick for the loss of value to its trade secrets,
see Inco Electroenergy, T.C.M. (P-H) 1987-437, but C&F,
unlike Inco, consistently alleged it was entitled to lost
profits as a type rather than amount of damages;
“[t]he subject of the possible impact of [the trade secret
misappropriation] on [C&F’s] sales” did not arise “only
No. 10-1555 13
in [C&F’s] attempt to place a value on the damage
to” the trade secrets, id. The factual allegations incorpo-
rated into C&F’s misappropriation claim highlight vast
reductions to C&F’s margins, see Second Am. Compl. ¶ 40,
C&F’s financial losses, see id. ¶ 42, the disproportionate
impact Pizza Hut’s conduct had on C&F’s total sales, see id.
¶ 47, and C&F’s inability to “exploit” its C&F process, id.
¶ 49. The shareholders did not offer the tax court evi-
dence which undercut the Commissioner’s reasonable
conclusion that the damages C&F alleged were the
main attraction rather than mere placeholders; their
sole attempt to do so was (properly) rejected on
hearsay grounds. They likewise failed to make any effort
to explain why they voluntarily treated some of the
money they received for a virtually identical claim
(trade secret misappropriation against IBP) as ordinary
income if all such claims necessarily net capital gains.1
Based on the record before it, the tax court did not err
in upholding the Commissioner’s presumptively correct
determination that the settlement was not “in lieu of” a
replacement of capital. Cf. Sager Glove, 311 F.2d at 212
(similar finding in context of antitrust suit).
We are similarly unmoved by the shareholders’ alterna-
tive argument, that the alleged misappropriation and
subsequent settlement payment in fact constituted a
protracted commercial transaction in which a capital
asset held for more than a year was exchanged for
1
When asked about this inconsistency at oral argument, the
shareholders’ attorney asserted that the judgment from IBP
“should have been properly taxed as capital gain.”
14 No. 10-1555
money. In their view, Pizza Hut “bought” a capital asset
when it misappropriated the C&F process, then com-
pleted the sale or exchange years later by “paying” C&F
with the settlement. See Lehman v. Comm’r, 835 F.2d 431, 435
(2d Cir. 1987) (noting that the fact that taxpayer did not
receive compensation for alleged sale for more than
16 years did not “militate[ ] against finding that the
payment was within [26 U.S.C.] § 1235”).
This argument grows out of 26 U.S.C. § 1222(3), which
defines as “long-term capital gain” proceeds from the “sale
or exchange of a capital asset held for more than 1 year,”
and 26 U.S.C. § 1235, which provides that “[a] transfer . . .
of property consisting of all substantial rights to a
patent . . . shall be considered the sale or exchange of
a capital asset held for more than 1 year.” (The parties
agree that trade secrets are analogous to patents for
purposes of § 1235. See Vision Info. Servs., LLC v. Comm’r,
419 F.3d 554, 561 (6th Cir. 2005); Pickren v. United States,
378 F.2d 595, 599 (5th Cir. 1967) (“Secret formulas and
trade names are sufficiently akin to patents to warrant
the application, by analogy, of the tax law that has
been developed relating to the transfer of patent rights,
in tax cases involving transfers of secret formulas and
trade names.”); see also Milgrim on Trade Secrets § 11.04 &
n.316.) The shareholders contend that Pizza Hut
deprived C&F of all the economic value of, and thus
almost all of the substantial rights to, its trade secret
when it misappropriated the C&F process back in the
1980s. See 26 C.F.R. § 1.1235-2(b) (defining “all substantial
rights to a patent” as “all rights . . . which are of value
at the time the rights to the patent . . . are transferred”);
Ruckelshaus v. Monsanto Co., 467 U.S. 986, 1011 (1984)
No. 10-1555 15
(“Once the data that constitute a trade secret are
disclosed to others, or others are allowed to use those
data, the holder of the trade secret has lost his
property interest in the data.”). The only valuable right
C&F had left in their view was “the right to pursue a
claim against Pizza Hut for unauthorized use or disclo-
sure,” which C&F gave up in exchange for the settle-
ment payment in 2002. See Am. Family Mut. Ins. Co. v.
Roth, 485 F.3d 930, 932 (7th Cir. 2007) (noting that trade
secrets, once sold, can no longer be used by the seller).
The facts of the case undermine their position, how-
ever. The tax court found that Pizza Hut disclosed the
C&F process to IBP in 1989. Four years later, C&F filed
suit against both Pizza Hut and IBP. It secured a
sizeable jury verdict against IBP for trade secret misap-
propriation. To achieve such a result, C&F had to
have possessed—and exercised—its right to exclude
others, not just Pizza Hut, from using or disclosing
its protected process. See Ruckelshaus, 467 U.S. at 1011
(“With respect to a trade secret, the right to exclude
others is central to the very definition of the property
interest.”); E.I. Du Pont De Nemours & Co. v. United
States, 288 F.2d 904, 911 (Ct. Cl. 1961) (“No disposition
of a trade secret is complete without some transfer of
this right to prevent unauthorized disclosure.”); Milgrim
on Trade Secrets § 11.04 (“To qualify as a sale under the
[Tax] Code the owner of a trade secret must give the
transferee the ‘right to use the trade secret’ and in addi-
tion convey ‘his most important remaining right, the
right to prevent unauthorized disclosure (and effectively
the right to prevent further use of the trade secret by
others).’ ” (quoting Du Pont, 288 F.2d at 912)). C&F neces-
16 No. 10-1555
sarily retained a rather valuable right associated with
its trade secret (at least until technological advances
rendered the once-groundbreaking C&F process obso-
lete), one that was not transferred to Pizza Hut at any
point during the 13 years separating the misappropria-
tion from the settlement payment. C&F could not have
transferred all substantial rights in its trade secret
while simultaneously keeping a $10.9 million right to
exclude IBP in its back pocket. “[A] seller that transfers
less than all substantial rights to a trade secret generally
is not eligible for capital gain treatment.” Milgrim on
Trade Secrets § 11.04.
Moreover, the settlement agreement gives no indica-
tion that Pizza Hut believed it was compensating C&F
for the sale or even the use of its trade secrets. See
Lehman, 835 F.2d at 435. It states only that $15.3 million
was tendered “in consideration of the dismissal with
prejudice of the lawsuit,” not in exchange for anything
else Pizza Hut previously or concurrently received.
Transactions involving the transfer of capital assets
must be “in the nature of a sale” to qualify for capital
gains treatment. Milgrim on Trade Secrets § 11.04; cf.
Helvering v. Hammel, 311 U.S. 504, 510-11 (1941) (holding
that forced sales of capital assets constitute “sales” for
tax purposes and emphasizing sale-like characteristics
rather than voluntariness of transaction). Here, the tax
court expressly concluded that “Pizza Hut did not pay
the amount at issue under the settlement agreement
for C&F’s sale or exchange of the C&F trade secret to
Pizza Hut.” Without at least some hallmarks of a sale,
C&F’s transfer to Pizza Hut of its trade secrets should
not be considered one for tax purposes.
No. 10-1555 17
The tax court rightly concluded that the settlement
payment did not represent the final phase of a 13-year-
long transfer of a capital asset. Because there was not
a complete transfer of all substantial rights, there was
no “sale” of a capital asset or long-term capital gain
resulting therefrom.
III. Conclusion
The tax court sustained the Commissioner’s determina-
tion that the proceeds C&F received from the settlement
of its trade secret misappropriation claim should be
taxed as ordinary income. This conclusion was neither
clearly erroneous nor legally incorrect. We therefore
A FFIRM the judgment of the tax court.
M ANION, Circuit Judge, dissenting. After several years
of time and money invested in developing a unique
process of making and freezing pre-cooked sausage,
C&F Packing successfully patented what became the
trade secret that is the focal point of the tax issue before
us. The question is straightforward: whether the settle-
ment proceeds received by C&F should be classified
as capital gain or ordinary income. The court agrees
18 No. 10-1555
with the Tax Court’s decision that they should be
classified as ordinary income. I disagree and conclude
that the settlement proceeds should be classified as
capital gain. And so, I respectfully dissent.1
I agree with the court and the Tax Court on the rule
that “[t]he classification of amounts received in settle-
ment of litigation is to be determined by the nature
and basis of the action settled.” Nahey v. Commissioner, 196
F.3d 866, 868 (7th Cir. 1999). But based on the record
before us, I disagree with the Tax Court’s conclusion
that the nature of the claim brought by C&F against
Pizza Hut is a claim for lost profits. Rather, it is a claim
for the value lost when the trade secret was misappro-
priated by Pizza Hut.
When the litigation began, C&F brought claims
against both Pizza Hut and its competitor, IBP. Most of
the claims were dismissed for reasons not relevant here,
but two claims remained viable: a claim of trade secret
misappropriation against IBP for unlawfully using C&F’s
trade secret when it processed and sold sausage to
Pizza Hut, and a claim of trade secret misappropriation
1
On appeal, C&F brings two arguments. With respect to C&F’s
second argument, I agree with the court that the Tax Court
correctly ruled that the settlement payment did not constitute
the sale of a capital asset. Clearly there was no sale, and it
would be difficult to equate the value of an arm’s-length
sale with an asset that was unilaterally misappropriated. It
is with respect to C&F’s primary argument that I part ways
with the court.
No. 10-1555 19
against Pizza Hut for wrongfully disclosing C&F’s trade
secret.
Although the district court initially dismissed the
claim against Pizza Hut, the claim against IBP was suc-
cessful, with a jury awarding C&F $10.9 million in dam-
ages. When it came time to calculate its taxes, C&F deter-
mined that approximately $2.86 million of the total
award corresponded to the amount of profits that C&F
had lost by IBP’s trade secret misappropriation. In other
words, had IBP not been using C&F’s trade secret,
Pizza Hut would have bought more sausage from C&F
instead of IBP, and $2.86 million corresponded to the
profits from these lost sales with Pizza Hut. Thus, C&F
treated that portion of the jury award as ordinary
income and treated the remainder as capital gain. 2 The
Commissioner apparently had no objection to this charac-
terization. On appeal, the D.C. Circuit reversed the dis-
missal and reinstated C&F’s trade secret misappropria-
tion claim against Pizza Hut. With only the trade secret
misappropriation claim against Pizza Hut remaining,
Pizza Hut then settled for $15.3 million. The Tax Court
concluded that the settlement proceeds were for lost
profits.
But C&F did not lose profits to Pizza Hut—it lost them
to IBP when Pizza Hut transferred the business to IBP.
2
Because most of the $10.9 million jury award was first
disbursed to attorneys and shareholders, C&F ultimately
received only about $4 million. C&F then reported to the
Commissioner its income in proportionate amounts—about
$1 million in ordinary income and $3 million in capital gain.
20 No. 10-1555
What C&F did lose to Pizza Hut was value to its trade
secret when Pizza Hut misappropriated it. In light of the
IBP verdict, the profits lost to C&F from purchases
that Pizza Hut made with IBP instead of C&F have
already been accounted for in the jury award, and any
additional money recovered from Pizza Hut cannot
correspond to money from lost sales. In its opinion, the
Tax Court dismissed this issue, saying that C&F could
have also lost profits attributable to Pizza Hut that
were not attributable to IBP. Nothing in the record sup-
ports that finding: instead, C&F’s case is limited to
Pizza Hut giving the secret to one competitor, IBP; C&F’s
lost profits went to IBP from IBP’s sausage sales to
Pizza Hut; and these profits were recovered as part of
the jury award against IBP.
The Tax Court is wrong because it misread the com-
plaint. In the complaint, after describing the elements of
its trade secret misappropriation claim against Pizza
Hut, C&F alleged that “[a]s a result, C&F has been dam-
aged, and has suffered, among other things, lost profits,
lost opportunities, operating losses and expenditures.”
[Tax Court decision, Appendix p.32] From this one
phrase of “lost profits,” the Tax Court concluded that
C&F was only seeking lost profits against Pizza Hut.
This is an incorrect way of reading the complaint. Recall,
the complaint when first filed was against Pizza Hut and
IBP. The nature of the claim that C&F was bringing
against Pizza Hut was that Pizza Hut had wrong-
fully acquired and then disclosed a trade secret to
C&F’s competitor, IBP. This undoubtedly damaged C&F’s
No. 10-1555 21
property interest in the trade secret. 3 Accordingly, in
the complaint, the phrase “lost profits” was part of a
non-exclusive list describing ways C&F had been injured
by Pizza Hut’s trade secret misappropriation. But this
phrase “lost profits” did not negate the fact that
C&F’s trade secret had been severely damaged and that
C&F was also seeking compensation for this damage.
The Tax Court erroneously discarded the neighboring
phrase “lost opportunities” which easily includes, for
example, the lost opportunity to negotiate a transfer of
the secret process to another pizza giant after Pizza
Hut cut C&F off. The Tax Court was clearly wrong to
conclude that the claim against Pizza Hut could only
be for lost profits and that it wasn’t also to compensate
the injury to its trade secret, when the only profits lost
3
The Commissioner makes the argument that C&F’s trade
secret did not lose value because it was not publicly distributed.
But the fact that the disclosure was not public is not relevant;
the value of the trade secret was still damaged by the disclosure
to IBP because C&F had lost its competitive advantage to IBP.
See Ruckelshaus v. Monsanto Co., 467 U.S. 986, 1012 (U.S. 1984)
(“With respect to a trade secret, the right to exclude others
is central to the very definition of the property interest. Once
the data that constitute a trade secret are disclosed to others,
or others are allowed to use those data, the holder of the
trade secret has lost his property interest in the data. . . . The
economic value of that property right lies in the competitive
advantage over others that [the holder of the trade secret]
enjoys by virtue of its exclusive access to the data, and disclo-
sure or use by others of the data would destroy that competi-
tive edge.”)
22 No. 10-1555
were those transferred to IBP. And as discussed above,
at the time of the settlement, C&F had already received
compensation for its lost profits by means of the jury
award.
Although the Tax Court concluded that Pizza Hut
paid the settlement to C&F for lost profits, there is
nothing in the record indicating that the parties under-
stood the settlement proceeds to be a payment equivalent
to C&F’s lost profits—there are no calculations in-
dicating the equivalency between C&F’s lost profits
and the settlement amount. Instead, Pizza Hut paid the
settlement proceeds to C&F in an agreement to settle
all past, present, and future claims against Pizza Hut, in
typical boilerplate language contained in any litigation-
ending release agreement. And the only issue in that
final phase of the litigation following the IBP verdict
was the damage to the trade secret asset.
Other than its reliance on the single “lost profits” refer-
ence in the complaint, the Tax Court does not cite
to anything in the record which supports the position
that C&F’s remaining claim against Pizza Hut was
for lost profits. In fact, the record contained direct testi-
monial evidence to the contrary, which the Tax Court
rejected as unreliable based on its reading of the “lost
profits” phrase.
In sum, the “nature and basis” of the trade secret misap-
propriation claim, at the time when Pizza Hut entered
into its settlement agreement following the IBP verdict,
was a claim seeking compensation for the substantially
diminished value inflicted upon the trade secret. See
No. 10-1555 23
Nahey, 196 F.3d at 868. And since a trade secret is a
capital asset, the settlement should be characterized as
capital gain.
I respectfully dissent.
8-26-11