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APRIL 9 - 15, 2012
CRAIN’S CLEVELAND BUSINESS 15
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SMALL BUSINESS
In forming litigation strategy, consider awards’ tax implications
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or some small businesses, litigation is a regular part of doing business. For others, it is a rare event. Either way, business owners should be aware that there can be significant tax consequences to litigation and that your litigation strategy should consider those potential tax consequences from the start. The tax issue usually is whether the receipt of money from a judgment or other settlement of a claim is ordinary income or capital gain. While it would seem that the rules on the taxability of settlement payments should be clear, the analysis is not always straightforward. The tax treatment will depend on the facts and circumstances in dispute and the nature of the claims made by the parties. It is important to understand what is at stake. For any business entity other than a C corporation, if a settlement is treated entirely as a capital gain, the maximum federal tax rate for that income is 15%. However, if the same income were taxed at ordinary income rates it could be subject to up to a 35%
federal tax (in each case using 2012 rates). For those small businesses that operate as limited liability companies or S corporations, significant tax savings can be realized if the proceeds can be treated as a capital gain. The test for determining how settlement proceeds are taxed is called the “origin of the claim” test. If the underlying claim is related to lost profits, the settlement proceeds likely are to be ordinary income. If the claim is related to damage to a capital asset, the proceeds are more likely to be taxed as a capital gain. A recent federal appeals court decision applied this test to the settlement of a trade secret dispute. In this case, a meat processing company filed a lawsuit against another meat processor and a national pizza chain, claiming misappropriation of a trade secret. The company was successful, winning a verdict of more than $10 million from the other meat processing company and a settlement of $15 million from the pizza chain. The company claimed that the $15 million payment was a capital gain.
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TAX TIPS The IRS, the U.S. Tax Court and the federal appeals court disagreed, declaring the full $15 million to be ordinary income. Why would there be confusion as to the treatment of settlement income from this type of case? Trade secrets themselves are capital assets. Thus, settlement money for any damage or impairment of a trade secret could be treated as a capital gain. However, trade secrets also produce ordinary income by generating profits and, if licensed, royalty income. It is this distinction that creates the ambiguity. In this case, the “origin of the claim” might have arisen from separate aspects of the trade secret. The
settlement could be for lost profits and royalties, lost opportunities or operating losses and expenditures. Alternatively, the settlement could have been for the fact that the trade secret was destroyed or damaged due to the nonpermitted use. There can be both capital gain and ordinary income components within a single settlement. In this case, the company’s court filings focused on lost profits, lost opportunities and operating losses. On the tax return and in tax court, the company asserted that the settlement should be considered a capital gain, but it was too late. The appeals court, noting the tax ambiguities that this type of claim presents, looked for indications of the parties’ intent as to what the settlement represented. Noting the claims originally were made for lost profits, and noting the lack of any claim relating to damage to the property itself, the appeals court found that all of the settlement proceeds were ordinary income. Lost profits often can be the best measure of damage to property, and the case does not indicate that using
Online rep: Activity plays role in hires
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WHAT TO DO, AND DON’T
aintaining your online reputation these days is no longer as simple as making sure that ridiculous photo from your college days doesn’t end up on Facebook. It’s become much more about creating a favorable impression. “Think of yourself as a brand. … I think that is code critical,” said Lori Pennica Hedrick, an associate partner at Marcus Thomas LLC. “Every time you hit the keyboard ... think before you hit enter.” Ms. Hedrick, who is in charge of human resources at the Warrensville Heights integrated marketing communications agency, said she looks for positive social media activity when recruiting. It not only shows that the person is engaged, but “they add value to their profession,” she said.
■ It’s not always advisable to “check in” with Foursquare while at work. A client may not want it broadcast with whom it is working. ■ Don’t “spam” for connections. Use Twitter as a way to gradually build a relationship with someone. ■ Treat your LinkedIn profile like a traditional résumé. Don’t accept invitations from people you don’t know. ■ Don’t necessarily connect your LinkedIn profile with other sites, like Facebook and Twitter. For example, Ms. Hedrick said LinkedIn can be a primary way recruiters find people. So when someone has not taken the time to fill out their profiles, it speaks volumes. “My initial impression is there really isn’t a lot of substance to this person,” she said. Lori Long, associate professor of
business administration at BaldwinWallace College, noted that for those who mix professional and personal social media activity, it’s important to be conscientious about what and how often you post. Case in point: Don’t post on Facebook or tweet every hour when you should be working. And, even when you aren’t working, Ms. Long said it can build a negative perception if you are constantly online commenting, especially about things on which you aren’t an expert. Christina Klenotic, director, social media strategist at Rosetta, said she’s struck by how many people don’t capitalize on and promote their social media profiles for professional purposes. After all, she said, social media savvy is a way for younger professionals to differentiate themselves. “You position yourself at a competitive advantage,” she said.
Did you know the average life span of a major league baseball is 7 pitches?
Mr. Grassi is the president of McDonald Hopkins LLC.
FOLLOW THE LEADER: A Q&A MARY KAYE DENNING
By AMY ANN STOESSEL astoessel@crain.com
lost profits to calculate damages means the proceeds always will be taxed as ordinary income. In this case, the company argued that the lost profits were just a “measuring stick” for the damages to the underlying property. The court acknowledged that while this was possible, the claim in the original complaint focused on the lost profits, not the property damage. If the firm had been able to assert damage to the trade secret in its original complaint, in addition to, or in lieu of, the lost profits, and consistently argued in its pleadings and in the settlement that its capital asset had been damaged, the tax results could have been more favorable. In short, do not assume that the tax treatment of business disputes is a black and white determination. Consider the tax consequences even as you state the original claim for relief and throughout your case to be sure that you position any recovery for the most favorable tax treatment available for that type of claim. ■
Founder and president Manufacturing Mart
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ary Kaye Denning is all about making connections. The founder and president of the Manufacturing Mart, which is located in the Galleria, came to Cleveland roughly five years ago with the intention of creating connections between manufacturers and those needing products. After familiarizing herself with the community and working with Magnet, she opened in 2010 the Manufacturing Mart, which now strives to “deliver a better, simpler client experience for getting new customers.” In fact, an expo held earlier this year aimed to make connections between those involved in all aspects of the manufacturing process. Ms. Denning said there have been some challenges in terms of changing people’s habits. But, “the veneer of that is cracking,” she said. ■ Last book read? “Abundance:
The future is better than you think,” by Steven Kotler and Peter H. Diamandis. ■ Favorite TV show? Masterpiece Theater ■ Who do you admire and why? Nelson Mandela. He never lost his faith. ■ What most surprises you about the path your career has taken? I was born in rural North Carolina. I was working in tobacco by the age of 5, and manufacturing shoes for the Queen of Holland by the age of 25. Some wonder how my life happens. ■ What skill do you wish you had? The ability to translate what I see and do into a business proposal that would result in an investment/ team needed to launch the Capital of Know-How — Manufacturing Marketplace. ■ If you weren’t in your current occupation, what would you be doing? Kick-starting another new industry, opening a new company, launching a new product with the codicil of a little more free time. ■ Career advice you wish someone would have given you? Learn to fail faster.
Another little-known fact:
As a COSE member, you could be pitching a whole lot of new business when you participate in the COSE Leads Groups. And that’s just one of the benefits of an annual membership that works out to about $25 a month. Find out how COSE can help your business start knocking them all out of the park. CALL 216.923.0838 OR VISIT COSE.ORG/ANSWERS2 Health plans insured by Medical Mutual