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 share, etc.).
  • 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 damages.
        • See Clark v. Commissioner (40 B.T.A. 333 (1939)).
  • The Appellate Court found for the Raytheon.
    • 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 income.
      • This is now known as the Substitution Theory.
    • 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.
      • See 26 U.S.C. 1001.