Raytheon Production Corporation v. Commissioner
144 F.2d 110 (1944)
Raytheon sued RCA for an anti-trust
issue related to some patent claims. They won a $410k settlement.
The details of the
anti-trust case were complicated but essentially Raytheon claimed that
RCA infringed on their patents, ruined their cathode-ray tube business,
and damaged their company's 'goodwill' (e.g. their brand name, market
Out of the $410k Raytheon
received, they estimated the value of the patents at $60k. They filed
taxes claiming the $60k as gross income and excluding the remaining $350k.
The IRS claimed that the $350k
that Raytheon received for the settlement of the suit was also taxable as gross
income. Raytheon disagreed.
Raytheon argued that it
wasn't gross income at all, but a replacement
of capital, which was not taxable.
Ant-trust lawsuits are
based on the idea that the plaintiff has been damaged by the defendant.
Raytheon claimed that they weren't getting income, but that they were just being reimbursed for
See Clark v.
Commissioner (40 B.T.A. 333
The Appellate Court found for
The Appellate Court found
that the $350k represented a replacement of capital intended to reimburse Raytheon for the loss of
their cathode-ray tube business.
The Court suggested that
the question to ask was, "in lieu of what were the damages awarded."
If the damages were for
loss of profits due to an injury on your business (like say someone
breaks your finger and you can't perform in that concert so you don't
get paid for playing), then the damages are a substitute for lost
profit and are taxable as gross income.
On the other hand, if the
damages were for loss of a capital item (like say someone burns down
your house and pays to build you a new house), then the damages are to
replace what you lost (aka replacement capital), and are not taxable as gross
This is now known as the Substitution
However, the Court found
that when RCA reimbursed Raytheon for the loss of a business unit, that
was basically the equivalent of RCA buying the business unit form
Raytheon. Unfortunately for Raytheon, that meant that they had realized the value of the business, and would have to
pay taxes on the realized gain
(aka the amount realized
- adjusted basis) of the
cathode-ray tube business
The Court found that the adjusted
basis of the business unit was almost
nothing. So almost all of the payment made to Raytheon ended up being
taxable anyway, because it was made in excess of reimbursement.